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.
How To Borrow From Your 401k Account
To borrow from your 401k loan to finance a down payment, youll need to talk to your employers benefits office or HR department, or with your 401k plan provider. You can also consult your plan document to find out if your plan permits borrowing from your 401k to purchase a home.
Youll want to find out how much youre able to borrow, the interest youll have to pay, and the repayment period. Additionally, ask about repayment options, such as whether your employer will deduct the monthly payment from your paycheck or if they will allow you to make 401k contributions while you pay back the loan.
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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Using Your 401 For A Down Payment As A First
Home prices keep rising which means saving the required down payment for your first-time home purchase can be tough.
But as a first-time home buyer, taking money from your 401 to buy a home is likely not the best option.
First-time home buyers are often at a key age for making retirement contributions. The more cash you put in when youre young, the more time your money has to accrue compound interest.
- Say you have $30,000 in your 401 at age 30
- After 25 years at 7% interest, that $30K will have grown to $162,800
Now imagine you take out $10,000 to make a down payment on your first home.
- Your 401 now has $20,000 in it at age 30
- After 25 years at 7% interest, it will have grown to $108,500
- So $10,000 withdrawn now means $54,000 less in your 401 at retirement
This isnt to say a 401 loan or withdrawal is always the worst option.
But before you turn to your retirement savings, consider all the other routes available for first-timers to purchase a home.
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.
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Benefits Of Borrowing From Your 401k To Buy A Home
The great thing about 401k loans is that they dont count towards your debt-to-income ratio. Using a 401k loan to finance your down payment can put you in a more favorable position for financing your mortgage. And, these loans are not reported to the credit bureaus, so they dont impact your credit score. It can also be beneficial to borrow from your 401k as a first time home buyer in order to make a higher down payment, especially in a competitive housing market. That said, you should consider the monthly payments on your 401k loan along with your monthly mortgage payment to ensure that these payments are within your budget.
Can You Gift 401k To Buy A House
Gifted funds can be used to make a home down payment, but your refinance mortgage lender will need to know some details before allowing you to use it. Only two specific groups are allowed to give first-time home buyers money to fund their down payment.
- Government agency: as part of a program dedicated to allowing first-time buyers into the market
- A family member or a friend: As long as the standing relationship with the home buyer can be proven. The gift letter used for this purpose and signed by both interested parties must explicitly state that the money is a gift, with no expectation of repayment. In many cases, there is absolutely no limit on the amount of gift money destined to go into a down payment, as long as the individual is a first-time home buyer aiming for a primary residence. However, if you decide to use the gifted down payment to buy a second home or an investment property, you will have to pay at least 5% of the down payment, while the rest can be a gift.
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Withdrawal To Buy A House
Usually, youre not supposed to withdraw funds from your 401 until age 59. If you lose or leave your job, you can withdraw at age 55. Any withdrawal before this gets a 10% early withdrawal penalty, plus taxes you must pay on any 401 withdrawal.
If you need more than $50,000 or your 401 provider does not allow loans, then you will need to make a withdrawal. This has special rules its called a hardship withdrawal. Usually, the IRS allows it if you need money to pay for a primary residence.
There are two drawbacks:
- Youll almost certainly pay a 10% penalty exceptions are available, but they are rare
- Youll owe income tax on the amount, which cannot be more than your financial need
In effect, this means youll end up paying income tax on your withdrawal out of pocket, no matter how much you need to spend. Plus, your 401 will lose some of its growth. Even if you start to rebuild as quickly as you can, youre sure to lose a big amount of future value.
Restrictions On Investment Returns
When you enrolled in your 401, you should have received a Summary Plan Description which tells you what you can and can’t do with your plan contributions and balances. In some cases, you will not be earning investment returns while you are repaying the 401 loan.
Similarly, you may also be restricted from making new 401 contributions until the loan is fully repaid.
Be sure to speak with your Human Resources department or your financial investment planner for clarification on anything that may seem confusing.
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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.
Make A 401 Withdrawal
Your second option would be to make a direct 401 withdrawal for your home purchase. As mentioned above, this is the less desirable of the two options.
An early withdrawal would be classified as a hardship withdrawal. The IRS considers any emergency removal of funds from a 401 to cover an immediate and heavy financial need as a hardship withdrawal. Whether or not the purchase of a home using your 401 counts as a hardship withdrawal is a determination that falls to your employer, and you will need to present evidence of hardship before the withdrawal can be approved.
Regardless, you will still likely incur the 10% early withdrawal penalty. There are exemptions in place for specific circumstances, including home buying expenses for a principal residence. Qualifying for such exemptions is difficult by design, however. If you possess other assets that could be used for your home purchase, then you likely wont qualify for an exemption. Even if you do, your withdrawal will still be taxed as income.
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Disadvantages Of Borrowing From 401 For Real Estate Investments
Home buyers are discouraged from using their 401 account to invest in real estate. There are other downsides in using your 401 plan to buy a house.
1. Tax Effect when you Borrow from 401
The tax from the loan on your 401 plan will be taxed multiple times and Ellen Chang has enumerated the tax effect of your borrowing from the 401 plan, The money you borrowed is being taxed twice since you pay taxes on your salary and are using your pay check to repay the loan. Once you retire, you are faced with paying taxes again on the money being withdrawn.
2. Early Withdrawal from the 401
Should you leave your job or get fired from your job, it is treated as an early withdrawal from the 401 account. This gives you sixty to ninety days to repay the mortgage loan and you will incur an additional ten percent penalty tax. Moreover, you would need to pay the income tax related to your loan from the 401 account.
If you are unable to pay the loan, you are also considered to be making a taxable withdrawal that is subject to ten percent tax.
3. Halts Growth of Money
When you have an outstanding 401 loan, you cannot make a full contribution to your existing retirement plan which means that are letting go of up to 15 years worth of retirement fund contributions. If you add up the total amount of employers contribution that you are letting go for the next fifteen year, this sums to a rather sizable amount.
Can I Use My 401 To Buy A House
Using your 401 to make a down payment on a house is generally allowed. And there are even some benefits: 401 loans arent taxed and they have low interest rates.
However, borrowing from your 401 can do severe and lasting damage to your retirement savings. So its generally not recommended as a down payment source.
Before you decide to use your 401 to buy a house, consider the no- and low-down-payment mortgages available today.
Many people can buy a house with as little as 3% or even 0% down so theres a good chance you dont need to tap your retirement savings to make a down payment.
In this article
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Using Money From An Ira
Although the answer to, Can you borrow against an IRA? is, No, you can withdraw the amount you need if you and any co-buyers havent owned a house in the past two years. If you have owned a house and take money out for a home purchase, the entire balance of the IRA becomes taxable income.
If youre thinking about using an IRA to buy a house, it might be worth looking into alternatives, especially if you dont qualify as a first-time homebuyer. The IRS doesnt allow loans from any IRA-based plan, including SEPs, SARSEPs, and SIMPLE IRA plans. However, if you have a government pension or any annuity plan, its worth checking to see if you may be able to take a loan that you can repay in five years.
Its important to note that rules regarding an IRA apply specifically to Traditional IRAs. If you have a Roth IRA, the money you contributed went in after tax. That means you can withdraw your contributions at any time without paying penalties or taxes on the funds .
Is There A 401 First
Unfortunately, at this time, there is no such thing as a first-time homebuyer 401 withdrawal exception. While there is an IRA exemption that lets qualified, first-time homebuyers borrow up to $10,000 from an IRA without paying tax on the early deduction, this exemption does not currently exist for those borrowing from a 401.
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What Is A 401 Loan
401 loans let employees borrow money from their 401 balances and pay that money back at an interest rate determined by the plan administrator.
Withdrawals are typically limited to 50% of the accounts total value, with a $50,000 limit. Loans must be repaid within 5 years and until the loan is paid-in-full, buyers may not make new 401 contributions.
Option : 401 Withdrawals
Not all plan providers allow 401 loans. If they don’tor if you need more than the $50,000 loan maxthen you have to go with an outright withdrawal from the account. You are likely to incur a 10% penalty on the amount you withdraw unless you meet very stringent rules for an exemption. Even then, you will still owe income taxes on the amount of the withdrawal.
You’re only limited to the amount necessary to satisfy your financial need, and the withdrawn money does not have to be repaid. You can, of course, start replenishing the 401 coffers with new contributions deducted from your paycheck.
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Withdrawing Money From Your 401
If you do not want to get a 401 loan for your down payment, then withdrawing money is another option. However, like borrowing money from your 401, there are pros and cons to withdrawing money from your 401.
The first thing that you need to know about making a 401 withdrawal is that many employer plans simply do not allow 401 withdrawals before the age of 59 ½. Check with your plan provider or employer to see if a withdrawal is even an option.
Many employers allow 401 withdrawals before this age, under certain circumstances. One of these circumstances is financial hardship. But your employer may require you to demonstrate that you are experiencing financial hardship before they allow you to make a withdrawal.
If you are able to make a withdrawal from your 401, there are many advantages to using it as a funding source. For example, the money does not have to be repaid. Also, unlike a 401 loan, the IRS does not set a limit regarding how much you are allowed to withdraw.
Further, you will not be required to pay any interest on your withdrawal. This is a great benefit.
Now for the disadvantages: If you are under the age of 59 ½, you will be charged a 10% early-withdrawal fee. So, right off the bat, you lose 10% of the money you take out.
But that is not all an early withdrawal will cost you. The withdrawal is considered income, so you will pay federal and state taxes on the amount withdrawn.
Q: When Would You Recommend Not Using A 401k Loan To Finance Home Remodeling Or Repairs
DistilledDollar: If you plan on leaving your employer soon, then taking out a 401k loan will not help you. Once you are either terminated from your employer or leave voluntarily, you must repay the remaining balance of the loan within 30 to 60 days, depending on your employer.
Another scenario where I would not recommend a 401k loan is if you are nearing the age of 59 1/2. The amount of time you have to repay your loan is diminished. If you take out a 401k loan and are unable to repay by 59 1/2, then you will need to pay regular income taxes in addition to the 10% early withdrawal penalty.
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Pros And Cons Of Borrowing From Your 401k
When Using Your 401K to Buy a House is a Good Idea
While most financial advisors will strongly advise you not to use your retirement funds for your down payment on a house, there are certain situations where it could save you a lot of money.
Avoiding PMI with a 20% down payment
Lets say youre buying a $300,000 home with a $30,000 down payment with a 5% rate for 30 years. You will be required to carry private mortgage insurance because youre putting less than 20% down. Your monthly payment will be $1,449.42, including insurance, property taxes, and PMI of $112.50 monthly.
If you can borrow another $30,000 from your 401k account, you will have a $60,000 down payment, 20% of the purchase price. You avoid PMI and have a monthly mortgage payment of $1,288.37, a savings of $161.05 per month over 30 years, saving you $57,978 over the life of the loan.
Becoming a First-Time Homeowner
Buying a home is cheaper than renting in the long run. Not only can you save money each month, but you will also be building equity with each payment.
If you can Pay Back to Loan in Less than a Year