How To Use Your 401 To Help Buy Your Home
You usually hear that its imperative to save for retirement as early as you can. That advice will serve you well as you get closer to retirement age and all of that planning starts to become reality.
Much of the expert advice and guidance you receive from your trusted connections will also generally tell you to avoid withdrawing or taking out loans from any of your retirement plans, such as a 401.
But what about when youre trying to buy a home and take out a mortgage? Is it a good idea to leverage your 401 to help you cover your down payment or closing costs? Will it end up costing you more in the long run? We will break down what you should know about using your 401 to get a mortgage here.
What Are The Rules & Penalties For Using 401 Funds To Buy A House
Heres a side-by-side look at some key differences between taking out a 401 loan and withdrawing funds from a 401.
| 401 loans | 401 withdrawals |
|---|---|
|
Must be repaid with interest in a certain period of time usually 5 years. Qualified loans are penalty free and tax free, unless the borrower defaults or leaves their job before closing the loan. The maximum loan amount is 50% of the vested account balance, or $50,000, whichever is less. Interest accrued on the loan goes back into the 401, so the borrower is basically paying interest back to themselves. The interest is also tax-deferred until retirement. If the borrower doesnt repay the loan on time, the loan is treated as a regular distribution and subject to taxes an early withdrawal penalty of 10%. |
Do not have to be repaid. Usually allowed only in the case of financial hardship, which can include medical expenses, funeral expenses, and primary home-buying expenses, if the individual meets strict IRS criteria for hardship. Subject to income tax and a 10% early withdrawal penalty for people under age 59½. One can only withdraw enough to cover the immediate expense , with a limit of 50% of the vested balance or $50,000whichever is less You can only withdraw enough to cover the immediate expense , with a limit of 50% of the vested balance or $50,000 whichever is less. |
How Does Repayment Work On A 401 Loan
Typically, you have five years to repay a 401 loan. However, if youre using the loan to purchase a primary residence, that time frame may be extended. The exact time frame youll have for repayment will depend on your plan, but in some cases, it can last up to 25 years.
In either case, you must make payments on the loan at least quarterly and each payment must be of a similar size.
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What Are The Penalties Fees Or Taxes Involved In Borrowing From Your 401
If you borrow the money, youll be required to repay the loan, typically within 5 years. Youll be paying interest while you do it, which is generally at the interest rate of 2 points over the prime rate. But the interest will be used to pay yourself, which makes it a bit less onerous. However, remember these loans are paid with after-tax dollars so youre missing out on the tax benefits that make 401 accounts so attractive in the first place.
And note that if you use a 401 loan and then leave your job, the full amount must be repaid before you file taxes for the year in which you left your job . If you dont, its considered a withdrawal, which means it will be taxed at ordinary income tax rates.
Get A Gift From A Loved One
Another alternative to using a 401 to buy a house is to ask for a gift from a loved one. Gift money can be used for a down payment as long as the lender can verify the source of the funds and the person giving the gift submits a statement that says the money is truly a gift and not a loan.
While parents typically give their children gifts, depending on your loan program, the gift may be able to come from another source. For instance, Fannie Mae allows gift funds to come from an immediate family member, fiancé or domestic partner, while the FHAs list includes family members, employers, close friends and charitable organizations, as well as organizations or agencies providing homeownership assistance.
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Alternatives To Withdrawing Your 401 To Purchase A Home
The penalties associated with taking money out of a 401 are high enough to make someone consider other alternatives. Fortunately, theres more than one way to receive the necessary capital to buy a home. Prospective homebuyers dont have to use a 401 to buy a house instead, they can turn to one of the following sources of capital:
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Mortgage Programs
Should I Use My 401 For My Down Payment
The first question for many buyers thinking about using their 401 to help cover their down payments or closing costs is, Is this really a good idea? The answer depends on your personal financial situation.
Your 401 is meant to be your retirement plan, so withdrawing funds from it early can disrupt your retirement planning and come at a cost.
You have to consider your overall financial situation, though. If youre able to save on your housing costs versus renting, and youre buying in an area with healthy home value appreciation, that might justify the short-term costs you incur to take funds from your 401.
If you do end up taking from your 401, youll want to develop a realistic plan to ensure youre still on track for your retirement goals.
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Find Out How Much You Need To Save
First thing first, consider how much you actually need to save. Of course, buying a home is an expensive endeavor. But you might be surprised to learn that you dont need to save as much as you think.
Traditional wisdom suggests that you put down at least 20% on a home purchase through a conventional loan. However, the plentiful low money-down loans could mean you dont need to save quite so much.
For example, you may be able to put down as little as 3.5% with an FHA loan. Or even 0% with a VA loan. Explore your low money-down loan options to see what you might qualify for.
Look Into Down Payment Assistance Programs
If you dont want to use a 401 for your down payment, you can always look into down payment assistance programs. These programs are meant to help buyers with low-to-moderate incomes shoulder the burden of paying their down payment and closing costs. Programs like these are typically available on a federal or state level, though sometimes they can be made available at the municipal level as well.
Often, the assistance will come in the form of a forgivable grant, a low-interest or deferred-payment loan or simply a second mortgage. However, each down payment assistance program is different, so if youre thinking of going this route, your best bet is to talk to a lender in your area who can give you an overview of your options.
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A Note About The Cares Act
Signed into law on March 27, 2020, the $2 trillion dollar Coronavirus Aid, Relief and Economic Security Act emergency stimulus bill was drafted to help those affected by the coronavirus pandemic. Under the act, 401 account owners can make a hardship withdrawal of up to $100,000 without paying the 10% penalty. The bill also grants the account holder 3 years to pay the income tax, rather than it being due within that same year.
Disadvantages Of Using 401k To Purchase A Home
While there are advantages to using your 401k to buy a house, not least of which includes homeownership, you might want to exhaust all your other options first.
Thats because there are downsides to using your 401k for a real estate deal too, which you should be aware of so there are no surprises down the road.
- By taking money out of your 401k plan to buy a house, you could potentially miss out on profits in the financial markets. As a result, when it comes time to retire, your savings will be smaller than they would otherwise be in your golden years.
- If you take a distribution, your tax bill will be anywhere from 10-20% higher than it would otherwise be if you did not make an early withdrawal.
- If you take a loan, the funds must be repaid which could cripple your cash flow for years as you make regular payments. These funds might be automatically deducted from your pay considering your employer is the sponsor of a 401k plan. As a result, you will have a smaller paycheck than you otherwise would.
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What Is The Debt Limit
The debt limit, which is set by Congress, represents the maximum amount the federal government is allowed to borrow to pay its debts.
If the amount of government debt reaches that threshold and lawmakers fail to lift the borrowing limit, the U.S. would be unable to pay what it owes and could default.
It’s important to note that when Congress raises or suspends the debt ceiling, it isn’t greenlighting new spending. Instead, it is giving the go-ahead for the Treasury to pay for spending that has already been approved.
The Real Estate Investment Process Using Your 401k:
Once you are sure your 401k plan allows you to self-direct your funds, you can begin the process of making a real estate investment. Be aware that you are not going to be given a list of real estate properties available to you. It is up to you, as the owner of the 401k account to find the property or note you want to buy. You should also keep in mind that you are assuming all associated risks of investing in real estate, but you are also going to receive all the benefits of such an investment.
After you locate the property you want to buy, simply make a request to your plans administrator to ask the plans trustee to purchase it with your funds. This process is all done through written communication so there is a concrete record of your purchase. The trustee will ensure all the paperwork is in order and will make the purchase. At that point, the funds you use to purchase the real estate will be deducted from your 401k account.
Again, using your retirement funds to purchase real estate is a great option, particularly right now when the market is improving. You have the opportunity to increase your retirement income and funds through your own self-directed actions. If you have never considered a 401k real estate investment before, perhaps now is the right time.
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How To Use A 401 Loan To Buy A House
A 401 loan is the preferred method if you need to cash out some of your 401 retirement funds to buy a house. Thats because theres a much lower cost associated with a 401 loan compared to a 401 withdrawal.
You should also know:
- A 401 loan is usually not counted in your debt-to-income ratio, so it wont hurt your chances of mortgage qualifying
- 401 loans are not reported to credit bureaus, so applying for one wont harm your credit score
Depending on the program and the underwriter, they may hit you for this payment in terms of DTI, even though it isnt on your credit report, cautions Jon Meyer, The Mortgage Reports loan expert and licensed MLO.
How Can Irar Help
Financial planning isnt as simple anymore as dumping a small portion of your income into a 401 account or an IRA. For nearly 30 years, our dedicated team of self-directed IRA experts have helped clients build wealth through alternative investments like real estate, at a lower cost.
We provide investors of all levels with resources that explain the regulations governing self-directed retirement accounts so they can make an empowered decision to put themselves in the best position financially.
Book a free self-directed IRA consultation with one of our experts today to learn more about how you can leverage a self-directed account to put yourself on the pathway to greater financial freedom.
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Using Your 401 To Buy A New Home: Allowed But Not Recommended
You likely cant use your 401 to buy a house flat-out since there are limits to the amount of money you can take out.
It is possible to use your 401 to cover the down payment and closing costs on a home purchase. But as most financial experts will tell you, using your 401 to purchase a home typically isnt the best idea.
You have plenty of alternatives to your 401 to get cash for a down payment ones that wont have the same long-term ramifications as taking money from your retirement savings.
But maybe youve already looked at all your options and decided the money in your 401 is the best way to get the cash you need to purchase a home.
In that case, there are two ways you can access your 401 funds.
Here are the pros, cons, and rules for each method.
Can I Use My 401 To Buy A House
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For many would-be homeowners, the down payment is the biggest entry barrier to buying a house. While down payments can be as low as 3.5%, 20% is ideal if you want to secure a mortgage without monthly mortgage insurance fees.
If youre having trouble gathering funds for a down payment, you might find yourself considering using your 401 retirement fund as a convenient source of cash. While this is technically allowed, and could help you cover your down payment, it shouldnt be your first choice. There are some factors and drawbacks that you might want to consider before using your 401 to buy a house.
Well break down the pros and cons of making a 401 withdrawal for a home purchase, as well as some alternatives.
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When Using Your Retirement Savings Might Be Worth It
You should consider all other options before using a 401 account to finance your home purchase. The interest and penalty fees will substantially add to the cost of your home, and borrowing against your retirement savings can have severe financial consequences later in life.
However, if you need to buy a home and have no other option to secure funds for a down payment, borrowing against your 401 can provide the necessary cash. What is a 401 account if not a financial resource to be used to the fullest? If you need access to that money to buy a home, that alone may be reason enough to use your savings now rather than at retirement.
Rollover To A Roth Ira
You can avoid the 10 percent early withdrawal penalty and restrictions imposed on a 401 distribution by rolling over as much as $10,000 that youâve earmarked for building or buying your first home into a Roth IRA. However, because 401 funds are pre-tax contributions and Roth IRA contributions are post-tax, you must pay income tax on the money transferred to the Roth IRA. That means increasing your federal withholding, which will reduce your take-home pay.
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Making A Hardship Withdrawal
Depending on the terms of your plan, however, you may be eligible to take early distributions from your 401 without incurring a penalty, as long as you meet certain criteria. This type of penalty-free withdrawal is called a hardship distribution, and it requires that you have an immediate and heavy financial burden that you otherwise couldn’t afford to pay.
The practical necessity of the expense is taken into account, as are your other assets, such as savings or investment account balances and cash-value insurance policies, as well as the possible availability of other financing sources.
What qualifies as “hardship”? Certainly not discretionary expenses like buying a new boat or getting a nose job. Instead, think along the lines of the following:
- Essential medical expenses for treatment and care
- Home-buying expenses for a principal residence
- Up to 12 months worth of educational tuition and fees
- Expenses to prevent being foreclosed on or evicted
- Burial or funeral expenses
- Certain expenses to repair casualty losses to a principal residence
The home-buying expenses part is a bit of a gray area. But generally, it qualifies if the money is for a down payment or for closing costs.
