How To Buy Real Estate With A 401
A 401 can help fund real estate investments under certain circumstances.
Diversifying assets to include real estate can help you spread risk across a mix of investments. Whether buying property for direct use or for rental income, your 401 might be a funding source. The way you use a 401 for real estate investments determines any tax or penalty consequences you may face. It also can leave you with less money to fund your retirement.
Do You Know Your 401 Vested Balance
Once you know how much money you need, before you can take a loan from your 401 youll need to know your vested balance. Vested balance refers to how much of the employer-sponsored plan you can take to a new job or withdraw from the 401 at any given point in time. That number does not necessarily equal the accounts total balance.
Lets explain. While every dollar you contribute to a 401 is your money, you are not entitled to all of the company matching funds right away. Every year, a certain amount of the matching funds is vested, becoming part of your accounts balance. Once you are fully vested, you can then claim the entirety of your employers matching contributions.
As a caveat, every employer has different rules and regulations regarding the vesting period, so you may want to speak with your plan administrator if you have been with the company for fewer than six years . The Internal Revenue Service has a helpful entry on this topic.
Drawbacks To Using Your 401 To Buy A House
Even if it’s doable, tapping your retirement account for a house is problematic, no matter how you proceed. You diminish your retirement savingsnot only in terms of the immediate drop in the balance but in its future potential for growth.
For example, if you have $20,000 in your account and take out $10,000 for a home, that remaining $10,000 could potentially grow to $54,000 in 25 years with a 7% annualized return. But if you leave $20,000 in your 401 instead of using it for a home purchase, that $20,000 could grow to $108,000 in 25 years, earning the same 7% return.
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Smart Way To Use A 401 When Buying A House
If youre using a 401 early withdrawal to buy a house, its important that you only borrow what you need.
Being mindful, though, that you might have to borrow a little more to compensate for the 10 percent early withdrawal penalty and income taxes.
To illustrate, lets say you need $10,000 to buy a house. If you withdraw this amount, youll likely only receive $7,000 after the penalty and taxes. In which case, you would have to pay the additional $3,000 needed for mortgage-related expenses out-of-pocket.
Instead, it might be better to withdraw $14,000. This will cover the early withdrawal penalty and income taxes, leaving you with about $10,000 for the home purchase.
To reduce the amount withdrawn from a retirement account, one option is saving up some cash for the home purchase, and then borrowing a smaller amount from your 401.
Using the above scenario, you might use $5,000 cash from a liquid savings account, and borrow $5,000 from your retirement account.
Drawbacks To Tapping Your 401
There are a few scenarios where tapping your 401 for a down payment might make sense. For instance, you might consider it if you want to:
- Capitalize on rapidly appreciating home values and/or low interest rates
- Build equity sooner
- Obtain a more affordable mortgage payment
- Secure a home before youre priced out of the market
However, its generally not recommended to use your 401 funds to buy a house, even if the situation appears ideal.
Whether youre borrowing from your plan or taking a hardship distribution, the decision could have an enduring impact on your retirement savings.
If youre taking out a 401 loan, you might miss out on years of additional contributions and employer matching.
And, if you lose or leave your job, you might have to quickly repay the rest of your loan to avoid having it count as an early distribution thatll be taxed and penalized.
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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:
- 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.
Question : What Is Your Current Vested Balance
Your vested balance does not equal your total balance. Instead, this term refers to how much of your employer-sponsored plan would go with you if you were to leave your job or withdraw your 401 right now. While every dollar you contribute to your 401 is your money, the company-matching funds in your account are not immediately all yours. Every year, a certain amount of the matching funds is vested. Once youre fully vested, you can then claim the entirety of the employer match.
Note:Every employer is different with regard to the vesting period, and you will want to speak with your plan administrator if you have been with the company for fewer than six years . The IRS has a helpful entry on this topic.
Below is a snapshot of what Mark and Katies retirement plans look like:
Katie has been with her company just over two years and is only 20% vested. She also had a 401 at a previous employer rolled over into an IRA.
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Can You Use A 401 To Buy A House: Two Paths You Can Take
There are two paths to cashing out a 401 to buy a house: taking an early distribution or borrowing against your 401 balance. Heres an overview of both options:
|401 Withdrawals for Home Purchase||401 Loan for Home Purchase|
|Subject to Income Tax|
|Up to your contributions||The lesser of $50,000 or 50% of your vested account balance|
Buying A Home Is A Big Financial Investment And Even If You Dont Have The Cash To Purchase A Home Outright Youll Probably Still Need Money On Hand For A Down Payment
If you havent saved for a down payment, though, you might be considering other ways to get access to the money you need now, including your 401. Thats because some 401 plans let you borrow money from your retirement savings and pay it back over time.
But even if you arent planning to retire any time soon, taking a loan from your 401 can come with big drawbacks, like missing out on potential investment growth. So before you dip into your nest egg, consider if its really the best option for you.
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Can You Use Ira Money To Buy Land
You can hold real estate in your IRA, but youll need a self-directed IRA to do so. Any real estate property you buy must be strictly for investment purposes you and your family cant use it. Purchasing real estate within an IRA usually requires paying in cash, and the IRA must pay all ownership expenses.
Low And No Down Payment Mortgages
Instead of getting a loan for your down payment, you can look into some of the government-backed loans that offer low and no down payment mortgages.
FHA LoansFHA home loans require a low 3.5% down payment, making them a prevalent option. With a down payment this low, you may not need to use your retirement account to afford the down payment.
VA Loans If youre a Veteran, you could qualify for a VA home loan with no down payment. This is one of the greatest benefits offered to Vets in our Country. Not only do VA loans provide 100% financing, but no mortgage insurance is required.
USDA Loans The U.S. Department of Agriculture guarantees USDA loans for low-to-median income families in the countrys rural areas. TDA finances 100% of the purchase price for eligible borrowers.
Conventional 97 Loan This type of conventional loan was created by Fannie Mae to compete with the low down payment government-backed loans. As the name suggests, a conventional 97 loan offers a 3% down payment, allowing you to finance 97% of the purchase price.
Home Possible / HomeReady Loans Fannie Mae and Freddie Mac created the Home Possible and HomeReady loan programs for first-time homebuyers who meet the income limits, have a 620 credit score and a 3% down payment. Your income must be below 100% of the area median income to be eligible.
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Missing 401 Investment Returns
When you have an outstanding 401 loan, that money is not being invested or generating additional returns for your nest egg. Cannova notes that its not as big a deal if you happen to be borrowing when the market is doing poorly. However, if the market is returning 8 to 10 percent and youre only paying 4 or 5 percent on your loan, thats a substantial difference that could limit your retirement savings. For example, if you had $25,000 earning five percent over just one year, youd make $1,250 less than if your rate was 10 percent.
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Employer Stipulations On 401 Mortgage Loans
Borrowing against a 401k plan is allowed by law, but that doesnt mean your employer allows it. Many small businesses simply cant afford it. Even so, loans are a feature of most 401k plans. If offered, an employer must adhere to some very strict and detailed guidelines on making and administering them.
Employers can impose their own requirements on 401 loans, including:
- Whether loans are permitted at all
- The number of loans allowed
- Whether loans must be for a minimum amount
- The interest rate that borrowers must pay
About 90 percent of 401 contributors have access to loans, according to research conducted by the National Bureau of Economic Research . NBER also found that on average the amount borrowed with a new loan is about $7,800, while the average total amount borrowed is about $10,000.
About 40 percent of plans surveyed by NBER allow workers to take out two or more loans at once. Over the course of five years, NBER found that nearly 40 percent of plan participants took out funds from their 401.
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Tap Your Ira Or Roth Ira Instead
Best for: First-time homebuyers who need $10,000 or less for a down payment
You normally need to be 59½ to take penalty-free distributions from your IRA, but the IRS allows an exception for qualified first-time homebuyer distributions.
As long as you put any early distributions of up to $10,000 toward buying or building your first home, you wont have to pay the additional 10% tax on it.
Should You Use A 401 When Buying A House
Buying a house can be a great investment, but its also expensive. Theres the cost of the property and ongoing monthly payments.
In addition, there are out-of-pocket expenses associated with getting the actual mortgage.
Nowadays, many home loan programs require down payments that range from 3 percent to 5 percent of the sale price.
Buyers are also responsible for their own closing costs. This is an extra 2 percent to 5 percent out-of-pocket.
If you dont have enough in personal savings, the good news is that you might be able to get your hands on funds.
If you have a 401, you can tap this account and use these funds for your down payment and closing costs.
But, should you?
Heres how using a 401 when buying a house works, and what you can expect from the process.
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Pros And Cons Of Using A 401 To Buy A House
Here are the pros and cons of using a 401 to buy a home, at a glance:
|Pros of Using a 401 to Buy a House||Cons of Using a 401 to Buy a House|
|Individuals may be able to purchase a home that they might otherwise not be able to afford.||Individuals cant make regular contributions to their 401 while making loan payments.|
|When using a 401 loan, individuals are borrowing money from themselves, so they dont owe interest to a bank or other institution.||Borrowed or withdrawn funds arent growing inside the 401 account, potentially derailing an individuals retirement savings.|
|Interest rates are generally low.||If a person doesnt qualify for a hardship withdrawal and theyre under age 59½, withdrawals would be subject to income tax and a 10% early withdrawal penalty.|
|You dont have to meet any credit requirements.||If a person leaves their job before the loan is repaid, the balance owed could be deducted from the remainder of their 401 funds as an offset. For those under 59½, the amount of the offset would be considered a distribution and the borrower would owe taxes and a 10% penalty .|
Loan Terms Change If You Leave Your Job
Finally, if an individual borrows from their 401 to purchase a home and leaves employment at their company , the loan balance may be deducted from their remaining 401 funds in whats called an offset. An offset is then treated like an early withdrawal, and potentially subject to taxes and a 10% penalty if the borrower is under 59½.
As an example: Derek is 35 and has $100,000 in his 401 and borrows $30,000 for a home purchase. He pays back $5,000 including interest, but still owes $25,000 when he takes another job. The remaining $25,000 would be deducted from his 401 as an offset, leaving $75,000 in the 401 or rollover IRA. Worse, the $25,000 would be treated by the IRS as an early withdrawal or distribution, and Derek would owe taxes, plus a 10% penalty .
Terms may vary depending on the terms of your loan, the plan rules, and whether you were impacted by Covid-19, and would be considered a qualified individual under the CARES Act.
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Buying Your First Home May Be One Of The Most Important Purchases You Ever Make Read On To Learn The Pros And Cons Of Using Your 401 To Purchase A House
What you’ll learn:
One of the biggest barriers to buying a house is saving enough money for the down payment. You may be able to get a loan with a down payment as low as 3.5%. Still, many experts suggest making a 20% down payment when buying a home. But deciding how you will come up with the down payment is often a key first step. For some, their 401 may be one source of funds for a down payment. Read on to learn whether dipping into your 401 to buy a home is the right decision for your situation.
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.
Step by Step Guide
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