How 401 Hardship Withdrawals Work
A hardship withdrawal is an emergency removal of funds from a retirement plan, sought in response to what the IRS terms “an immediate and heavy financial need.” It’s actually up to the individual plan administrator whether to allow such withdrawals or not. Manythough not allmajor employers do this, provided that employees meet specific guidelines and present evidence of the hardship to them.
According to IRS rules, a hardship withdrawal lets you pull money out of the account without paying the usual 10% early withdrawal penalty charged to individuals under age 59½. The table below summarizes when you owe a penalty and when you do not:
A 401 hardship withdrawal isn’t the same as a 401 loan, mind you. There are a number of differences, the most notable one being that hardship withdrawals usually do not allow money to be paid back into the account. You will be able to keep contributing new funds to the account, however.
Should I Make A 401 Withdrawal Instead
Withdrawing money from your 401 before retirement, as opposed to borrowing from it, is usually a bad financial move. Not only will you be taking the money that youve invested for your golden years leaving you with less for retirement you may be hit with an early-withdrawal penalty.
Unless youre 59½ or qualify for another exception, youll have to pay tax on the amount you withdraw plus a 10% penalty. Though that penalty may be waived on up to $10,000 withdrawn from a traditional, SIMPLE or Roth IRA if you use the money to buy, build or rebuild your first home.
If youre experiencing financial hardship, your plan may offer the option of a hardship withdrawal. Youll still need to pay tax on the withdrawal amount, and you may also need to pay the 10% penalty. But the amount you take for a hardship withdrawal cant be paid back to your retirement plan like a 401 loan can.
Alternatives To Using Your 401
If you have plenty of time before you plan on buying a house, it may be a better option to try to save up for the down payment so that you donât have to dip into your retirement savings. It could even be better for your retirement savings to stop your 401 contributions for a couple of years so that you can save up for the down payment on a house and avoid taking any withdrawals from your retirement savings. This way, your 401 can continue to grow even if you briefly stop contributing.
Another alternative to using your 401 is to use an IRA. If you do have an Individual Retirement Account , you should know that the IRS allows you to take up to $10,000 from your account to purchase a house without any penalty. If you do not have an IRA, you can rollover your 401 funds into an IRA, but this is only possible if you are no longer employed with the company that provided your 401 plan.
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How To Use Your 401 To Make A Down Payment On A Home
Buying a home is a significant part of the American Dream. But saving enough money for a down payment is usually the biggest obstacle for first-time homebuyers.
According to the National Association of Realtors, the average down payment on a home is around 11% of the purchase price. This translates to $33,000 on a $300,000 mortgage.
Eleven percent can add up to a significant amount of money. Plus, you will usually have to pay 2% to 5% for closing costs. The amount you put down will help determine your monthly payments, so it’s an important factor for homebuyers.
One method that some people use to finance their down payments is to tap into retirement accounts, such as a 401. There are two ways to use a 401 to finance a home purchase: borrow from it and withdraw money from it.
Here are the pros and cons of these two options.
Which Option Should You Choose
The option that is best for you depends on what your goals are and which downsides you are willing to deal with, as both options have downsides.
The biggest downside of 401 loans is that they have to be paid back. The biggest downside of 401 withdrawals is that you will take a massive tax hit. If your top priority is to prevent losing a lot of money, then you should consider going with the 401 loan.
However, if your top priority is to not have to pay back any money that you take out, then you should go with the 401 withdrawal.
Regardless of which option you take, your 401 will still take a big hit, at least temporarily. Removing any money invested in a tax-deferred retirement plan will prevent you from earning the compound interest that you gain if you leave the money in your 401.
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Who Qualifies For The Ira Exemption
To use money in your IRA to buy a house, you must be a first-time homebuyer. The IRS defines that status rather loosely. You are considered a first-timer if you haven’t owned a home at any point during the last two years.
So even if you owned a principal residence at some point in the past , you may well meet the first-time-buyer requirement. The keyword, by the way, is principal. If you’ve owned a vacation home or taken part in a timeshare during the last two years, the exemption can still apply.
You dont have to be the one shopping around. You can tap into your IRA and qualify for the exemption if the money is to help an eligible child, grandchild, or parent buy a home. And that’s even if you’re a homeowner now.
Since IRAs are individual retirement accounts, your spouse can also withdraw up to $10,000 from an IRA.
Use A Down Payment Assistance Program
Lastly, it’s also possible to receive help in the form of a down payment assistance program. Many states and municipalities offer grants for interest-free second loans to help ease the financial burden on first-time homebuyers. Ask your lender for more information on what programs are available in your area and how to qualify.
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When A 401 Withdrawal Might Make Sense
Despite the downsides, some homebuyers may decide that the benefits of early 401 withdrawal outweigh the risks. If you choose to leverage funds from your retirement savings to help afford a home, you may qualify for a hardship withdrawal status. This means you could access your money penalty-free and avoid the 10% fee While penalty-free access means you save a nice amount when accessing your funds, a hardship withdrawal can never be repaid into your 401you would be forfeiting that amount from your retirement savings altogether.
According to the IRS, a hardship withdrawal exemption must be proven to be used for an immediate and heavy financial need. Costs directly related to the purchase of a principal residence are sometimes considered an allowable exemption.
You may only withdraw the amount necessary to satisfy the immediate need and if you have any other assets that could technically be put toward a down payment, youre unlikely to be approved for hardship exemption. Even if your withdrawal does qualify for exemption status , youll still face income tax on the total amount withdrawn.
Go Around The Downpayment Barrier
If you want to buy your first home but have not yet been able to, chances are its the downpayment requirement thats stopping you.
According to the National Association of REALTORS®, the lack of downpayment savings is the biggest barrier to homeownership for many buyers.
It can be a challenge saving money when youre paying monthly rent. Fortunately, there are ways to speed up the process by borrowing some or all of the required money down.
Fortunately, many loan programs today require a small downpayment, or none at all, making it even easier to raise necessary funds. Low-downpayment programs include the zero-down USDA loan and 3.5 percent down FHA mortgage.
When you still come up short, financing a downpayment can be a real option.
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Other Down Payment Funding Options
Taking money from your 401 either in loan or withdrawal form is not the only way to come up with money that you can use for a down payment on a house. Here are some other options that are available:
FHA loans. If you’re a first-time homebuyer, you can get an FHA loan to finance your home purchase. With an FHA loan, you will not have to put down 1020%. Instead, you can put a minimum of 3.5% down as long as your credit score is above 580.
Gift from friends or family. If you have a generous friend or family member who is willing to help you out with a down payment, then this is a good option. Most lenders will allow gifts to be used for a down payment. However, the amount of gift money that can be used for the down payment may vary depending on the type of loan and the lender. Be sure to ask your lender what their policies are before you try to use a gift as a down payment.
One party that you are not allowed to get a gift from for a down payment is the seller. As Sullivan at HUD explains, “We have long prohibited that the sources of payment be the seller. It is critically important that there be separation between buyer and seller in the transaction. There was a time, for a while, when the FHA would insure mortgages where the buyer of the home was contributing a down payment that was financed by the seller. We found those loans to be incredibly risky and defaulted at a much greater rate. And so, we prohibited that practice.”
Retirement Savings Can Benefit
As you make loan repayments to your 401 account, they usually are allocated back into your portfolio’s investments. You will repay the account a bit more than you borrowed from it, and the difference is called “interest.” The loan produces no impact on your retirement if any lost investment earnings match the “interest” paid ini.e., earnings opportunities are offset dollar-for-dollar by interest payments.
If the interest paid exceeds any lost investment earnings, taking a 401 loan can actually increase your retirement savings progress. Keep in mind, however, that this will proportionally reduce your personal savings.
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Alternative Options For Securing Down Payments
Borrowing from your 401k can impact your retirement savings and cost you a lot of money if youâre unable to repay the loan, leave your job, or worse, canât afford your mortgage payment on top of your 401k loan payment.
Itâs best to explore other alternatives before deciding to withdraw from your 401k. Some other financing options include:
- IRA withdrawals – similar to 401ks, IRAs allow first-time home buyers to withdrawal $10,000 without penalty
- Find a starter home – if the home of your dreams is out of range right now, consider finding a less expensive home that better fits your budget and can be resold in 5-10 years
- Apply for an FHA or USDA loan – these loans only require 3.5% down payments, rather than the traditional 20%, making it easier for first-time buyers to secure funding
- Wait to buy a home – if you donât have enough savings to cover the down payment on a house, it might make sense to wait, add to your savings, and look again when you have more money available
How Do You Take A Withdrawal Or Loan From Your Fidelity 401
If you’ve explored all the alternatives and decided that taking money from your retirement savings is the best option, you’ll need to submit a request for a 401 loan or withdrawal. If your retirement plan is with Fidelity, log in to NetBenefits®Log In Required to review your balances, available loan amounts, and withdrawal options. We can help guide you through the process online.
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Alternative To Borrowing From 401k Or Ira To Buy A Home
Instead of borrowing from your 401k or IRA to buy a home, youre much better off building your after-tax savings and investments that can provide for a 20% downpayment. If you dont have at least a 20% downpayment in cash plus a buffer equal to 10% of the value of the house, you probably cannot afford to buy your first home.
Leverage is great on the way up, but terrible on the way down.
Renting is good value now in many parts of the country, especially if you live in an expensive coastal city. Take a look at my BURL strategy if you really want to invest in real estate.
The pandemic hit tiger cities like San Francisco, San Jose, DC, and New York City harder than 18-hour cities. Therefore, renting in big cities is a good deal.
For example, if it sounds absurd to pay $4,200 a month in rent for a two bedroom, two bathroom apartment in San Francisco, it is even more absurd to spend $1,350,000 buying the place!
At $1,350,000, the apartment is trading at 26X annual gross rent or just a 3.6% gross yield. After property tax and expenses, were talking under a 3% net rental yield , and thats assuming no mortgage!
However, buying real estate in big cities is a relatively better deal nowadays. Therefore, if you have been waiting to buy in places like New York City or San Francisco, the time is now as rents tick back up post pandemic.
You Could Derail Your Savings Progress
It might be your goal to buy that house right now, but tapping into your retirement fund to make it happen might take you away from your future financial goals, experts say.
“By tapping even a small portion of your retirement nest egg early, you run the risk of derailing the progress you have made in saving for retirement in addition to the penalties and taxes incurred,” says Kenny Senour, a financial planner. “It’s true that you can begin to replenish the money you take out through your future paycheck deferrals, but it can take a long time to rebuild depending on how much is taken out.”
Financial advisor Jenna Lofton says you may also lose out on compound interest if you pull out a large chunk of your savings and take years to pay it back.
“If there was ever an investment where compound interest works in your favor, this is certainly one,” says Lofton. “These accounts are designed to have you living as comfortably post-retirement as you can envision yourself doing during pre-retirement.”
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When A 401 Hardship Withdrawal Makes Sense
Many workers count on their 401s for the lions share of their retirement savings. That’s why these employer-sponsored plans shouldn’t be the first place you go if you need to make a major expenditure or are having trouble keeping up with your bills.
But if better options are exhaustedfor example, an emergency fund or outside investmentstapping your 401 early may be worth considering.
Taking Advantage Of Low Interest Rates
Eric Meermann, portfolio manager with the Scarsdale, New York, office of Palisades Hudson Financial Group, says that because housing prices across the country remain at reasonable levels and mortgage rates remain at historic lows, this is a good time to buy a home.
If all that’s preventing buyers from taking advantage of this market is a lack of down payment funds, taking a loan from a 401 plan can be a smart financial move, Meermann said. Buyers who wait might find that both fixed mortgage rates and adjustable mortgage rates have risen by the time theyre ready to buy.
“It can make sense to get you into the house now at a presumably lower price and lock in a low interest rate,” Meermann said. “This is opposed to taking the additional few years it may take to get the money together for the down payment otherwise, risking higher home prices and higher interest rates.”
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When Does Using A 401 For Down Payment Make Sense
The decision to go into your 401 for down payment money should only be made after careful analysis. You first need to check with your plan administrator to see if its allowed. Not all companies that maintain 401 savings plans offer a borrowing option. If its permitted, its time to explore all alternatives before deciding what makes sense.
Using a 401 generally only works in your favor if the money is used to avoid paying for private mortgage insurance on your home loan. Most conventional home loans require that you obtain and pay extra for mortgage insurance if your down payment is less than 20% of a propertys purchase price. Mortgage insurance typically costs 0.5% to 1% of the total value of the loan on an annual basis and must be paid each month until you reach achieve 20% equity in your home.
Before shopping for a home, use online tools or meet with a mortgage broker to determine how large a loan and down payment you can afford. Buying a home that you might struggle to afford could become a financial disaster, so its important to know what sort of mortgages are available and how much they will cost you a month based on current interest rates. Mortgage insurance is part of the equation if you cant cover a standard down payment.
Not all loans require mortgage insurance for down payments of less than 20%.