Alternatives To Using Your 401 To Buy A House
Even if youre short on cash and facing hardship, there are other options you might want to consider before tapping into your 401 account to cover the down payment on a house.
IRA Account
If you have an IRA, you should look there for extra funds before considering an early withdrawal from your 401. IRAs are built with special provisions for first-time home buyers, which the IRS defines as anyone who hasnt owned a primary residence within the previous 2 years.
Under these provisions, first-time home buyers are allowed to withdraw up to $10,000 without incurring the 10% penalty. However, that $10,000 is still subject to state and federal income taxes. If your withdrawal exceeds $10,000, then the 10% penalty is applied to the additional distribution.
A Roth IRA is an even better option, if you have one. Some plans allow you to make a hardship withdrawal, and up to $10,000 can be withdrawn tax-free for the express purpose of a first-time home purchase.
FHA Loan
A Federal Housing Administration loan is a government-backed mortgage with looser requirements designed to make it easier for first-time home buyers to purchase a property. This includes low down-payment options and lower credit score requirements. For this reason, an FHA loan may be a better option than making a withdrawal from your 401.
- Size of your down payment
The Bottom Line: Find The Mortgage Option Thats Right For You
Your 401 account may seem tempting as an untapped source of cash, especially if youre struggling to come up with the money for a down payment on your new home. While this is a viable option, and there are ways to mitigate the penalties, it should only be used as a last resort. Consider applying for a low down-payment loan like an FHA or VA loan, or, if you have one, making a withdrawal from your IRA.
Whatever you decide, make sure you consult with a mortgage specialist before committing to an option. Rocket Mortgage® has experts waiting to help you navigate the tricky waters of home loans. If youre ready to take that next step toward a mortgage, then get preapproved today.
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Final Word On Using A 401 To Buy A Home
It seldom makes good financial sense to take money out of your 401. The penalties for withdrawals are designed to make it costly to do so, and youll miss out on years of interest-free growth on the money you withdraw. If you are buying a house, tapping your 401 shouldnt be one of your first options.
That said, it can be the right move in a limited set of circumstances. If you really cant wait to buy a house, dont have an IRA, and dont qualify for low-cost mortgage programs, you could consider taking a 401 loan. Just make sure you are able to pay it back fairly quickly, so you continue to make the most out of your 401 plan.
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Should You Tap Your 401 To Buy A House
Borrowing from your 401 isnt advisable, but some experts say it can be done in a pinch.
I wouldnt recommend it, but I will say that a loan from your 401 has a flexible repayment schedule, says Zhouhere. You can pay within the five years, or you can pay faster than that without penalty. You can also pay what you borrowed through payroll deductions, but using the after-tax dollars.
Others urge homebuyers to never remove money from their 401 to buy a house.
Ive been representing lenders and borrowers for 15 years, and Id never advise this, says Matthew Carter, an attorney at Las Vegas Inc and Go.
Buyers might think they are just borrowing the money from themselves, but they are really borrowing it from the future. Theyre losing the interest and value they can build on that money to purchase a home that will likely put them into further debt, adds Carter.
Homeownership comes with a lot of unexpected costs, and borrowing from your future to suffer those costs is reckless, he says.
Still, in the current competitive real estate market, tapping your 401 might be a worthwhile move, as long as you run the numbers and know that you can afford the fees.
Rising home values alone should make people seriously consider borrowing from their 401, says Chris Barnett at eXp Realty in Birmingham, AL.
Tapping your 401 fund is ideal if you need quick cash for short-term liquidity, Zhouhere says.
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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How Can I Use My 401k To Buy A House Without Penalty
You might be wondering whether you qualify for the hardship withdrawal, which avoids the penalty charge. The hardship withdrawal allows people to withdraw money without paying the penalty – for reasons of medical debt, funeral costs, college tuition, etc.
Basically, it depends on the plan – some do allow first-time home buying purchases to count. You will need to examine the language of your employers specific plan. Keep in mind that in order to qualify for hardship withdrawal, you may need to show that you have no other funds to rely on .
Can I Use My 401k To Buy A House Without Penalty
Unlike a 401 withdrawal, a 401 loan is not subject to a 10% early withdrawal penalty from the IRS. And the money you receive will not be taxed as income.
The rules for using a 401 loan to buy a house are as follows:
- Your employer must allow 401 loans as part of its retirement plan
- The maximum loan amount is 50% of your 401s vested account balance or $50,000, whichever is less
- The loan must be paid back with interest , on a schedule agreed to by you and your 401 provider
- Typically, you cannot make 401 contributions while you have an outstanding 401 loan
Also, 401 loans typically need to be paid back over five years.
However, when the money is used to purchase a home, youre usually allowed to pay it back over a longer period of time. Rules vary by 401 company, so check with yours to learn more.
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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.
Alternatives To Tapping Your 401
Saving for a down payment is the simplest way to avoid tapping into 401 savings to buy a home. For most future homebuyers, this means a dedicated savings strategy, though this could still take many years to achieve.
Another option is to look for home loans that require a low down payment. There are three primary programs:
- VA loans allow eligible service members and their families to buy a home with no down payment.
- U.S. Department of Agriculture loans offer no-down-payment loans to qualified buyers who plan to buy a home in an eligible, rural area.
- FHA-backed loans make it possible for some buyers to purchase a home with as little as 3.5% down, as long as they meet certain credit score requirements.
Rather than pull savings from a 401, first-time homebuyers can look into down payment programs in their state. Many of these programs offer down payment assistance and other incentives to eligible buyers when purchasing their first home.
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What Is A 401 Retirement Plan
401 retirement plans are investment accounts with automatic tax breaks.
Congress made 401 plans possible when it passed the Revenue Act of 1978. The bi-partisan bill modified the Internal Revenue Code Section 401 and eliminated taxes on deferred employee compensation.
By 1981, the IRS changed its rules so employers could fund retirement plans, and today, more than half of U.S. workers participate in an employee-sponsored 401 retirement plan.
The IRS supports two 401 plan types:
- Traditional 401: Contribute tax-free and pay taxes upon withdrawal.
- Roth 401: Contribute taxed dollars and pay no taxes upon withdrawal.
Employers typically provide a traditional 401 or a Roth 401 plan as part of an employee benefits package.
Is It Wise To Use Your 401 To Buy A House
While its possible to use your 401 to buy a house, its far from ideal. The loss of investment income over time may outweigh the short-term benefits of having more money for a down payment. Theres no guarantee your home will appreciate enough to justify the loss of retirement funds.
Borrowing as little as $10,000 can have a huge impact on what you have available for retirement. For example, $10,000 with a 7% annualized rate of return would become just over $76,000 in 30 years. For that reason, most experts would agree funds in your retirement account should stay there until you retire.
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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%.
Can I Take Out A 401 Loan Without Penalty To Purchase A Home
While not all 401 plans allow you to take out a loan from your account, a good many do. Vanguard reported that in 2020, 79% of its 401 plans allowed participants to borrow from their retirement accounts.
Be sure to check with your plan sponsor to see whats allowed. If your retirement plan allows you to take a loan from your 401, you may be able to use that money for a home down payment or closing costs.
Here are some things to consider before you take out a 401 home loan.
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Choose An Ira Provider
Step one is deciding where you want your money to go. If you already have an IRA and would like to roll your funds over into that account, you can skip to step 3. Otherwise, youll want to spend some time researching different brokerages and retirement account products. Important factors to benchmark include minimum balance requirements, investments, and customer service options. Bankrate.com offers the latest reviews of the top brokerages so that you can make some comparisons.
Again, only first-time home buyers can withdraw from their IRA accounts without penalty. Further, that is only if the funds are being used to purchase a home. If you arent a first-time homebuyer and want to invest in real estate, research self-directed IRA providers. You would then be able to withdraw funds to invest in real estate without penalty. Remember the important caveat that the real estate purchase cannot be for personal use.
Using Your 401k To Purchase A Primary Residence
When you are first considering using your 401k or your traditional IRA to purchase real estate, it is a good idea to talk to your plan provider, plan administrator, or custodian.
According to the IRS rules, you are able to use the retirement funds in your 401k to buy a house.
If it is for your first home that will be your principal residence, you can have access to the money in your 401K.
There are two options when it comes to using your 401k to help you purchase a home.
You can either borrow money in the form of a loan or take the money from the 401k as a withdrawal.
The amount of money you are able to borrow from your 401k depends on the number of years you worked at your company and the guidelines of the IRS.
The amount you can borrow is the greater of $10,000 or half of the balance in your account that has been vested, but the loan cannot exceed $50,000.
If your company allows loans from your 401k, you will not be subject to an early withdrawal penalty.
However, you will incur a penalty if you leave your job before paying back your loan within a specific time frame.
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How Much Can You Borrow From Your 401
Even if your 401 plan allows loans, theres a limit on how much you can borrow typically up to 50% of your vested balance, with a maximum loan amount of $50,000.
Lets say you have a vested balance of $130,000 in your 401 account. In this scenario, you wouldnt be able to borrow the full 50%, or $65,000, of your vested account balance. The most youd be able to borrow would be $50,000.
Some plans make an exception to the 50% rule, although theyre not required to: If 50% of your vested account balance is less than $10,000, your plan may allow you to borrow up to $10,000.
You usually must repay the loan within five years. But if you use your 401 home loan to buy a house that will be used for your primary residence, some plans may give you more than five years.
K First Time Home Buyer: Do You Have An Ira
For first-time homebuyers who dont have access to as much equity, borrowing from their 401k might be the most reasonable option for a difficult situation.
If you have an IRA account, youre in luck because they come with special provisions for first-time home buyers. You can withdraw up to $10,000 in order to buy a home without triggering the 10% penalty .
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Pros And Cons Of Using A 401 Loan
How do you know if the strategy will work for you? You have to weigh the alternatives:
Pros:
- If the numbers work, a 401 down payment loan might have advantages. Compare what a monthly mortgage would cost with and without mortgage insurance, then compute how much you would have to pay back to your 401 each month if you were to borrow from it. Remember that mortgage insurance isnt tax deductible, so anything you spend on it is a loss. A 401 loan is money youre borrowing from yourself, so you dont lose anything.
- A home is an investment that typically appreciates over time, and the equity you build in it is an asset. When you eventually sell it, you usually can pocket a lot of its appreciated value tax free. If its an investment that makes sense to you, arranging the best finance package should be part of the equation.
- Mortgage insurance isnt cheap. Its a good idea to avoid paying it, but you need to consider your ability to repay the 401 before using it as a solution.
Cons:
Borrowing From Your 401 To Buy A House
Buying a home is an exciting milestone, but it often requires a significant financial investment. While it’s important to calculate how much home you can afford and how your monthly mortgage payments will affect your budget, there are other costs to consider.
Two of the most important are your down payment and closing costs. According to the National Association of Realtors, the median home down payment was 12% of the purchase price in 2019. That would come to $24,000 for a $200,000 home. Closing costs, which include administrative fees and other costs to finalize your mortgage loan, add another 2% to 7% of the home’s purchase price.
While the seller may pay some of the closing fees, you’re still responsible for assuming some of the costs. You can borrow from a 401 to buy a house if you don’t have liquid cash savings for the down payment or closing costs. Here’s what to consider before you make that move.
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