Using Your 401 To Buy A House: Allowed But Not Recommended
You likely cant use your 401to buy a house flat-out since there are limits to the amount ofmoney you can take out.
It is possible to use your 401 tocover the down payment and closing costs on a home purchase. But as most financial expertswill tell you, using your 401 to purchase a hometypically isnt the best idea.
You have plenty of alternatives to your401 to get cash for a down payment ones that wont have the same long-termramifications as taking money from your retirement savings.
But maybe youve already looked at allyour options and decided the money in your 401 is the best way to get thecash you need to purchase a home.
In that case, there are two waysyou can access your 401 funds.
- Youcantakea loanfrom your 401 account,which will need to be repaid with interest
- Or you can simplywithdraw the money, which comes with a10% penalty and income tax from the IRS
Here are the pros, cons, and rulesfor each method.
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.
Borrowing From Your 401 To Buy A House
Doretha Clemons, Ph.D., MBA, PMP, has been a corporate IT executive and professor for 34 years. She is an adjunct professor at Connecticut State Colleges & Universities, Maryville University, and Indiana Wesleyan University. She is a Real Estate Investor and principal at Bruised Reed Housing Real Estate Trust, and a State of Connecticut Home Improvement License holder.
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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What Are The Cons
Besides the fees, your employer will likely stop their side of the match, if they were making one. Even when youre paying yourself back, they wont consider those funds a new contribution and therefore wont match it. It also might make it more difficult to qualify for a mortgage, as it can affect your debt-to-income ratio, but be sure to shop around to find a lender who will offer you the best program that fits your financial needs. And of course, youll lose out on the compound interest your money would have been earning if youd left it in the account.
Of course, if you decide to withdraw rather than borrow from your 401, the main con is the giant tax hit you will suffer.
Should You Invest Your 401k In Real Estate How
Do you want to get into the real estate investing boom but donât have the liquid cash to start? If so, youâre most likely considering the many financing options available to beginner real estate investors. One of the most common financing options is mortgage loans, but this is not the ideal option for everyone as there are requirements that can limit some investors. If you canât get a mortgage, consider other options for buying an investment property before giving up! For example, did you know that you can invest your 401k in real estate? Whether you want to buy a house for personal use or for rental income, read this to learn how your 401k can be a funding source to invest in real estate.
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Consider Your Financing Options Then Secure Financing
First-time homebuyers have a wide variety of options to help them get into a homeboth those available to any purchaser, including Federal Housing Authority -backed mortgages, and those geared especially to novices. Many first-time homebuyer programs offer minimum down payments as low as 3% to 5% , and a few require no down payment at all. Be sure to look into or consider:
Dont be bound by loyalty to your current financial institution when seeking a pre-approval or searching for a mortgage: Shop around, even if you only qualify for one type of loan. Fees can be surprisingly varied. An FHA loan, for example, may have different fees depending on whether youre applying for the loan through a local bank, , mortgage banker, large bank, or mortgage broker. Mortgage interest rateswhich, of course, have a major impact on the total price that you pay for your homecan also vary.
Once youve settled on a lender and applied, the lender will verify all of the financial information provided . The lender can pre-approve the borrower for a certain amount. Be aware that even if you have been pre-approved for a mortgage, your loan can fall through at the last minute if you do something to alter your , such as finance a car purchase.
Weighing Pros And Cons
Before you determine whether to borrow from your 401 account, consider the following advantages and drawbacks to this decision.
On the plus side:
- You usually dont have to explain why you need the money or how you intend to spend it.
- You may qualify for a lower interest rate than you would at a bank or other lender, especially if you have a low credit score.
- The interest you repay is paid back into your account.
- Since youre borrowing rather than withdrawing money, no income tax or potential early withdrawal penalty is due.
On the negative side:
- The money you withdraw will not grow if it isnt invested.
- Repayments are made with after-tax dollars that will be taxed again when you eventually withdraw them from your account.
- The fees you pay to arrange the loan may be higher than on a conventional loan, depending on the way they are calculated.
- The interest is never deductible even if you use the money to buy or renovate your home.
CAUTION: Perhaps the biggest risk you run is leaving your job while you have an outstanding loan balance. If thats the case, youll probably have to repay the entire balance within 90 days of your departure. If you dont repay, youre in default, and the remaining loan balance is considered a withdrawal. Income taxes are due on the full amount. And if youre younger than 59½, you may owe the 10 percent early withdrawal penalty as well. If this should happen, you could find your retirement savings substantially drained.
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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
Loans May Disrupt Your Contributions And Increase Taxable Income
Many 401 plans provide that if you take out a 401 loan, your contributions are suspended while you repay the loan. This means you’re no longer tucking away tax-deferred savings, and although the 401 loan repayment reduces your paycheck, those loan repayments are not tax-deferred contributions. The result is that you’re not making any tax-deferred contributions for up to five years, so your gross income for tax purposes is higher, and you may end up seeing a higher tax bill during the repayment period.
If you are permitted to make contributions while you repay the loan, you’ll have a lower paycheck, because you’ll be making contributions and making loan payments at the same time.
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Getting A 401 Loan For A Home
If you’d like to use your 401 to cover your down payment or closing costs, there are two ways to do it: a 401 loan or a withdrawal. It’s important to understand the distinction between the two and the financial implications of each option.
When you take a loan from your 401, it must be repaid with interest. Granted, you’re repaying the loan back to yourself and the interest rate may be low, but it’s not free money. Something else to note about 401 loans is that not all plans permit them. If your plan does, be aware of how much you can borrow. The IRS limits 401 loans to either the greater of $10,000 or 50% of your vested account balance, or $50,000, whichever is less. For example, if your account balance is $50,000, the maximum amount you’d be able to borrow is $25,000, assuming you’re fully vested.
In terms of repayment, a 401 loan must be repaid within five years. Your payments must be made at least quarterly and include both principal and interest. One important caveat to note: loan payments are not treated as contributions to your plan. In fact, your employer may opt to temporarily suspend any new contributions to the plan until the loan has been repaid. That’s significant because 401 contributions lower your taxable income. If you’re not making any new contributions during your loan repayment period, that could push your tax liability higher in the interim.
Contribution Limits For A 401
For the 2018 tax year, you cannot contribute more than $18,500 to your 401. If your employer also contributes to the 401, either through matching or through another type of program, those amounts don’t count toward the limit. In 2019, the contribution limit will increase to $19,000, and it will continue to increase over time to keep up with the cost of living.
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K Withdrawal: Pros And Cons
After looking at the potential pros and cons of taking on a 401k loan, it’s important to look at the other option: a 401k withdrawal. Unlike a loan, a 401k withdrawal doesn’t have to be paid back, but it does take away from your retirement savings.
We’ve listed the advantages and disadvantages of this method below so you can get a sense of whether doing a withdrawal is the right choice for you.
Using Your 401k For A Down Payment
Theres no specific penalty exemption for home purchases when you pull money out of a 401k, so any money you take out will be classified as a hardship exemption. Youll be assessed a penalty of 10% on the amount withdrawn and youll have to pay income tax on it as well.
If possible, roll over the amount you want to withdraw to an IRA, so you can avoid paying the penalty. However, you cant roll over a 401k thats with an employer for whom you are still working. If you have an old 401k from a former employer, roll that. Since a rollover can take time to process, fill out the necessary paperwork as soon as possible.
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Can I Take Out A 401 Loan To Buy A House
While not all 401 plans allow you to take out a loan from your account, a good many do. Vanguard reported that in 2018, 78% of its 401 plans allowed participants to borrow from their retirement accounts.
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.
One important distinction to note: You cant borrow money from an IRA.
Here are some things to consider before you take out a 401 home loan.
Have Questions About Investing Funds From Your Ira Or 401k Into Our Multifamily Fund Contact Us For The Pros And Cons
If youre reading this, you likely know that there is enormous value for investors in property investing. Real estate, particularly in multifamily and commercial properties, offers some of the highest ROI. But doing so takes a large investment of funds. What many prospective investors dont know is they may have those resources in their IRA and/or 401K. There are ways to use either of these to invest in multifamily and commercial properties.
With the stock market at record highs, many investors are looking to buy an investment property as a way of diversifying their portfolios. But with real estate also at record highs, it has created a dilemma for some investors: should they be saving for and investing in real estate, or should they stay the course and continue maxing out their retirement accounts?
Most people dont realize that it isnt an either-or situation.
In fact, it is possible to use both your 401k and individual retirement accounts to invest in real estate. And contrary to popular belief, it is possible to do so without suffering from steep withdrawal penalties.
There are some key differences between how to invest with either an IRA or 401k, which well cover in this article. This guide is intended to be an investors go-to resource for learning about how to leverage their retirement plans to buy an investment property, including the pros and cons of using this approach and alternative investment strategies to consider.
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Those Who Truly Need It
It really comes down to need. If you need to withdraw your money, then withdraw your money. Thats really the essence of the CARES Act. It simply makes a need-based withdrawal less harmful. If you dont need to, then dont, says Brandon Renfro, a financial advisor and assistant professor of finance at East Texas Baptist University.
Its important to consider what things will be like after you take a withdrawal and once things are back to a new normal. Under the CARES Act, you have to repay your withdrawal within three years. If you just need a withdrawal to get you through the next few months before you start earning regular paychecks again, it could be a good option.
Pros Of Using Retirement Funds For A Home
- You may be able to access retirement fund money more quickly than you can save up for a down payment or other initial home buying costs.
- With a larger down payment, you may be able to avoid costs like PMI.
- Youre not losing the money but rather moving it from one long term investment to a home, which often appreciates in value as well.
- If you borrow from your 401k, youll be paying the loan back with interest that goes into your account. This helps offset the loss of removing the funds from your account temporarily.
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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.
Planning Out The Timing Of Your Withdrawals
The timing of your early withdrawals is important, says Dave Lowell, certified financial planner and founder of Up Your Money Game.
If you were employed for most of the year and had a relatively high income, then it makes sense to not withdraw money under the rule of 55 in that calendar year, since it will add to your total income for the year and possibly result in you moving to a higher marginal tax bracket, Lowell says.
The better strategy in that scenario may be to use other savings or take withdrawals from after-tax investments until the next calendar rolls around. This may result in your taxable income being much lower.
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