K Loan: Pros And Cons
The first way to borrow from your 401k is to take out a loan. As the name suggests, some of this method involves borrowing the money temporarily and then paying it back with interest over time. We’ve listed the pros and cons of choosing to take out a loan so you can get a better idea of how this process works.
Why Use A Roth Ira To Buy A Home
Technically speaking, you can withdraw savings from almost any tax-advantaged retirement account to fund a first-time home down payment. IRS early withdrawal rules let you take out up to $10,000 of investment earnings penalty-free to fund the purchase of your first home. And the IRS considers you a first-time home buyer so long as you havent owned a home for the last two years.
But early withdrawals from accounts like your traditional 401 or individual retirement account still raise your tax bill. While youre off the hook for the 10% early withdrawal penalty, youll still owe income tax on everything you withdraw. Thats because your original contributions were tax free.
Withdrawals from a Roth IRA, on the other hand, are tax and penalty free as long as you first funded the account at least five years ago. But just because you can withdraw from your Roth IRA to finance your first home purchase doesnt mean you should.
Pulling money out of your Roth IRA could mean missing out on investment growth, says Eric Roberge, CEO and lead advisor of Beyond Your Hammock, a fee-only financial planning firm. However, it might make sense, depending on your situation.
If you no longer need your Roth IRA money for retirement, then you may be able to tap the account to generate the cash needed for the purchase, Roberge says.
Withdrawing Money From A Roth Ira
Using a Roth IRA to help buy a first home can be a smart alternative to borrowing from a 401 that might be beneficial for some home buyers. Unlike 401s, Roth IRA contributions are made with after-tax dollars.
Contributions can be withdrawn at any time, tax free earnings can be withdrawn without a penalty at age 59½ or older, as long as youve held the account for at least five years.
If youre under 59½ or dont meet the five-year criteria, some exceptions may apply for a first-time home purchase.
After the account has been open for five years, Roth IRA account holders who are buying their first home are allowed to withdraw up to $10,000 in investment earnings with no taxes or penalties. The $10,000 is a lifetime limit.
Roth IRA funds can be used to help with the purchase of a first home not only for the account holders themselves, but for their children, parents, or grandchildren.One important requirement to note is that time is of the essence when using a Roth IRA to purchase a first home: The funds have to be used within 120 days of the withdrawal.
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Pick An Asset Allocation That Matches Your Timeline
Figure out how long you have before you want to buy a home. Your timeline should be at least five years outunless you already have an established Roth IRA.
Once you know roughly how many years it will be before you buy a home, choose an appropriate mix of stock and bond funds. Your asset allocation should reflect the shorter time frame and reduce the risk involved, meaning youll probably want a greater percentage of bond funds.
Speak with a financial advisor about how to allocate your portfolio in a way that makes sense for your home down payment goal.
Paying Off The Mortgage With A 401k: The Advantages
When you retire, you have a few options for your old 401k . Some might decide to cash out a portion of their 401k to pay off the balance of their mortgage. This will wipe out the monthly payment, but youll still have taxes and insurance to take care of each year.
Freeing up that monthly payment each month might make your remaining retirement funds last longer but its also important to not replace the mortgage payment with other expenses.
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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.
Using 401k Funds For Down Payments
First-time home buyers who are unable to come up with a down payment can withdraw from their 401ks in order to gain access to funding quickly. When pulling from a 401k, borrowers only have access to the vested amount in their account, rather than the ending balance. This is simply because company matching funds may not be not immediately made available to pull from.
Withdrawing from your 401k before you hit retirement age always incurs penalties and fees. There are also different methods for withdrawing from your funding.
The hardship withdrawal option allows first-time home buyers to withdraw $10,000 from their 401k without incurring the 10% IRS penalty. However, buyers will have to pay income tax on this withdrawal come tax season.
The 401k loan option lets buyers borrower whichever of the below two options is less:
- 50% of the vested 401k balance
- Up to $50,000
Repayment terms are generally within 5 years and often come directly out of an employeeâs check.
A combination of the above two options can also be utilized if you have more than one 401k.
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Do You Qualify For A Mortgage Without 401 Funds
With such a wide range of mortgageoptions and down payment assistance on the market, most people simply dontneed to tap their 401 in order to purchase a home.
On top of that, todays lowmortgage rates increase your home buying power by reducing monthly payments.Its easier to afford a home than ever before.
Before taking money out ofretirement, find out whether you qualify for a mortgage based on your currentsavings. You might be surprised.
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If You Have An Old 401k Here’s What You Can Do
So, your options for investing in real estate are rather limited if you have an active 401k, meaning that you still work for the sponsoring employer.
On the other hand, if you have an old 401k, the possibilities are much greater.
While you can’t invest in real estate directly through an employer-sponsored 401k, you can choose to roll a former employer’s 401k account into an individual retirement account, or IRA. And while many IRA custodians don’t offer the ability to buy real estate, some offer an account type known as a self-directed IRA.
As the name implies, a self-directed IRA allows you to direct how your funds are invested, within the law. To be sure, there are some things you can’t invest in. For example, the law prohibits you from investing in collectibles with IRA funds. However, there’s nothing that specifically prohibits you from using a self-directed IRA to buy real estate.
- Things youcan buy with a self-directed IRA: Real estate, crowdfunded real estate investments, tax lien certificates, precious metals, cryptocurrencies, private equity investments.
- Things youcan’t buy with a self-directed IRA: Collectibles, such as coins, artwork, and antiques.
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Cons Of Borrowing From A 401k
While pulling from your 401k may seem like a great option, there are some drawbacks and risks involved. Top cons include:
- Paying interest on the amount withdrawn
- The full loan amount is due if you leave your employer before the loan is repaid
- In the case of a withdrawal, youâre pulling from your retirement fund, which can impact your financial health in the future
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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Using Your 401 To Buy A House: A Guide
If youve been dreaming of owning a home, youve probably imagined yourself cooking in the perfect kitchen or having a fenced yard for the dog. But making that dream come true requires an incredible financial commitment and the first step is to cobble together the cash youll need for a down payment and closing costs.
You may be wondering whether you should consider using the money in your retirement account toward the purchase of a home. Before you decide, you need to be aware that there are both financial and legal considerations to take into account.
Lets examine the pros and cons, and see whether using a 401 to buy a house is right for you.
Does A 401 Loan Or Withdrawal Make More Sense
When you consider the potential tax consequences associated with an early withdrawal, a 401 loan may seem more attractive. Of course, there’s one drawback with both options: you’re diminishing your retirement savings.
With a 401 loan, you’d have the ability to replace that money over time. If you’re cashing out an old 401, however, there’s no way to put that money back. In both cases, you’re missing out on the power of compound interest to grow your retirement wealth over time.
One upside of deciding to borrow from a 401 for a housewhether you take a loan or make a withdrawalis that it may allow you to avoid paying private mortgage insurance if you offer the lender a large enough down payment. Private mortgage insurance protects the lender, and it’s typically required if you’re putting less than 20% down on a conventional mortgage. Private mortgage insurance can be eliminated when you reach 20% equity in the home, but it can add to the cost of homeownership in the early years of your mortgage.
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Should You Use Your 401k For A Home Purchase
Your 401 should be the last place you look for down payment assistance. The government encourages you to keep money in this account to save for your retirement. Even with a 401 loan, you cannot make contributions for five years. The money in a 401 appreciates through investment returns. If you withdrew $20,000 out of your account today, with an annualized return of just 5%, you would be $86,000 poorer 30 years from now. There are also many other downsides associated with using your 401 for a home purchase:
- Early withdrawal penalties and increased taxable income
- Your 401 provider may charge you additional fees for early withdrawals or loans
- Since you cannot make contributions, you will lose out on any company matching programs that could double your contributions
- If you lose your job or quit, you will have to repay a 401 loan in full
Some homebuyers who cannot put a full 20% down payment are also offered an option to put less than 20% and takeprivate mortgage insurance instead. Since private mortgage insurance is paid by the borrower and protects the lender, many borrowers believe that they should avoid it at all costs. That is when they may think that it is better to withdraw money from their 401 instead of facing higher payments on the mortgage.
Using Your 401 For A First
If youre still thinking that you might want to go this route, its important to consider all the costs that will be part of owning a home, to make sure that youre not using your 401 as a way to fund a purchase that might be difficult to maintain. Looking at your retirement account balance might make you feel as though you have more money than you actually have coming in on a regular basis.
Buying a home might be the biggest purchase you make, but its important to remember that its not a one-time expense. Owning a home means regular costs for maintenance, upkeep, insurance, property taxes and much more. Its easy to get caught up in the excitement of house hunting and inadvertently make a first-time home buyer mistake that leaves you without sufficient funds to pay the ongoing expenses a home requires.
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Mortgage Interest Tax Strategy
Keep in mind that youll be deducting mortgage interest on your taxes after you purchase your home. This may actually wash with some or all of the income you report from a retirement account withdrawal.
For example, lets say you withdrew $25,000 from your 401k and paid $25,000 in mortgage interest the same year. The $25,000 youll report in additional income will wash with the $25,000 mortgage interest deduction. In other words, your taxable income wont be increased by the withdrawal, and you will effectively pay no tax on it.
However, you will still be liable for the 10% penalty, which is $2,500 in this case. This type of strategy can work for IRA, SIMPLE, and SEP withdrawals as well, but you wont be liable for the 10% penalty unless you withdraw more than $10,000.
Two Ways To Use A 401 To Buy A House
Taking a 401 distribution
The first method you can use to borrow money from a 401k for a down payment is to withdraw money or take a distribution without intending to pay it back. Unfortunately, this method of using retirement funds to buy a house can have some expensive tax consequences.
While withdrawing from a 401 is always considered a taxable event, depending on your age, theres a good chance that youll be taxed on the same money twice. To start, all 401 distributions are taxed as ordinary income. However, if youre under the age of 59 ½, your withdrawal will be considered an early distribution and youll have to pay an additional 10% early withdrawal tax.
Using a 401 loan
Instead of withdrawing from a 401 for a house, it might be a better idea to use a 401 loan for your home purchase. As the name suggests, you have to pay back a 401 home loan eventually, but as long as you follow the rules, the money you borrow is not taxable. That fact alone can make it a more affordable option than taking a 401 withdrawal for a home purchase.
First, you have to pay attention to how much you can borrow. While not all 401 plans allow for loans, if yours does, youre allowed to borrow up to 50% of your vested account balance or a maximum of $50,000, whichever is less.
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If Im Considering A 401 Loan What Information Should I Get From My Plan Provider
If youre considering taking a loan from your 401, ask your plan administrator for the following information:
- Whether or not loans are/are not permitted
- The minimum dollar amount required to obtain a loan
- The maximum number of loans permitted by the plan
- The maximum dollar amount permitted
- The term of repayment
- Any interest rate information
- Any required security for the loan
- How repayment may be made
- Any spousal consent requirements
Borrow Against Your 401
Borrowing from your 401 is generally the more advantageous option if you want to tap your plan for a down payment.
If your employers plan allows employees to take out loans against their 401 accounts, youll typically be able to borrow up to 50% of your vested account balance or $50,000, whichever is less.
Tip:
Youll then have to make more or less equal payments at least quarterly, with interest until youve repaid the loan. Youll typically need to repay it within five years.
Upsides
- Wont affect your credit
Downsides
Learn More: 401 Loans: Should You Borrow Against Your Retirement?
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