Retirement Funds Don’t Have To Be Off
Thomas J Catalano is a CFP and Registered Investment Adviser with the state of South Carolina, where he launched his own financial advisory firm in 2018. Thomas’ experience gives him expertise in a variety of areas including investments, retirement, insurance, and financial planning.
For those who invest in their 401 plan, the traditional thinking is to wait until retirement before taking distributions or withdrawals from the account. If you take funds out too early, or before the age of 59½, the Internal Revenue Service could charge you with a 10% early withdrawal penalty plus income taxes.
However, life events can happen, which might put you in a position where you need to tap into your retirement funds earlier than expected. The good news is that there are a few ways to withdraw from your 401 early without incurring a penalty from the IRS.
Should You Use Your 401k As A First
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Withdrawing money from a 401 to buy a house may be allowed by your company-sponsored plan, but this tactic is not always advisable, especially for first-time home buyers.
When it comes to using money from a 401, first-time home buyers need to keep in mind a few things, including the rules and penalties around early withdrawals from a 401 account as well as the potential loss of retirement savings.
Before you consider using a 401k to buy a house, consider alternatives like withdrawing funds from a Roth IRA, seeking help from a Down Payment Assistance Program , or seeing if you qualify for other types of home loans.
Lets take a look at the pros, cons, and important considerations that can help prospective homebuyers make a more informed decision about using funds from a 401 to buy a home.
Borrowing From Yourself For A Down Payment
Instead of making a straight withdrawal out of your 401, you could instead take out a loan from it. This is a great helpful way to supplement your down payment.
While you can borrow against your 401, note that you will be paying back yourself for the loans principal and interest, not to a bank. Rates usually compare well to mortgage rates. So since youre borrowing from yourself, you will have a variety of repayment options, from monthly payments to lump sums.
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Borrowing Against Your 401
So can you use your 401 to buy a house, and more importantly, should you? Yes, the money is technically yours so you can use it for anything you want or need it for, including as a 401 first-time home buyer.
While you can withdraw your money from the 401 plan in some cases, such as financial hardship, it can be more financially advantageous to borrow instead. But you do need to be aware of some of the potential downsides. Here are some questions to ask.
Making A 401 Withdrawal For A Home
Compared to a loan, a withdrawal seems like a much more straightforward way to get the money you need to buy a home. The money doesn’t have to be repaid and you’re not limited in the amount you can withdraw, which is the case with a 401 loan. Withdrawing from a 401 isn’t as easy as it seems, though.
The first thing to understand is that your employer may not even allow withdrawals from your 401 plan due to age. If they do allow employees to tap 401 funds early, you may have to prove that you’re experiencing a financial hardship before they’ll allow a withdrawal. Under the IRS rules, consumer purchases generally don’t fit the hardship guidelines.
You may be able to withdraw funds from a 401 plan that you’ve left behind at a previous employer and haven’t rolled over to your new 401. This, however, is where things can get tricky.
If you’re under age 59 1/2 and decide to cash out an old 401, you’ll owe both a 10% early withdrawal penalty on the amount withdrawn and ordinary income tax. Your plan custodian will withhold 20% of the amount withdrawn for taxes. If you withdraw $40,000, $8,000 would be set aside for taxes upfront, and you’d still owe another $4,000 as an early-withdrawal penalty.
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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.
Withdrawing From A 401
The first and least advantageous way is to simply withdraw the money outright. This comes under the rules for hardship withdrawals, which were recently made a little easier, allowing account holders to withdraw not just their own contributions, but those from their employers. Home-buying expenses for a “principal residence” is one of the permitted reasons for taking a hardship withdrawal from a 401.
You owe income tax on the withdrawal.
The withdrawal could move you to a higher tax bracket.
If you are younger than 59½, you also owe a 10% penalty on the money you withdraw.
You can never repay your account and lose years of tax-free earnings on the money you withdraw.
If you withdraw money, however, you owe the full income tax on these funds, as if it were any other type of regular income that year. This can be particularly unappealing if you are close to a higher tax bracket, as the withdrawal is simply added on top of the regular income. There is a 10% penalty tax, also known as an early withdrawal penalty, on top of that if you are under 59½ years of age.
401 plans do not have a first-time homebuyer exception for early withdrawals, but IRAs do.
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How To Use Your 401 To Make A Down Payment On A Home
Buying a home is a significant part of the American Dream. But saving enough money for a down payment is usually the biggest obstacle for first-time homebuyers.
According to the National Association of Realtors, the average down payment on a home is around 11% of the purchase price. This translates to $33,000 on a $300,000 mortgage.
Eleven percent can add up to a significant amount of money. Plus, you will usually have to pay 2% to 5% for closing costs. The amount you put down will help determine your monthly payments, so it’s an important factor for homebuyers.
One method that some people use to finance their down payments is to tap into retirement accounts, such as a 401. There are two ways to use a 401 to finance a home purchase: borrow from it and withdraw money from it.
Here are the pros and cons of these two options.
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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What You Should Know About Using A 401 Loan For A Home Purchase
Not all 401 plans allow loans, but many employers, especially larger companies, offer a loan feature. Your plan paperwork will indicate if it provides 401 loans, or you can check with your plans administrator.
Before taking a loan from your 401, make sure you have a plan. Only withdraw what you need loans are limited to the lesser of $50,000 or 50% of your vested account balance), and make sure you know how youll repay the loan. The typical 401 loan term is five years, during which borrowers will need to make similarly equal payments at least quarterly. Although, in the case of a 401 loan for a home purchase, borrowers have longer to pay the loan back up to 25 years with some plans.
Another factor to consider is that if you leave your job or are terminated, your employer may require you to pay the outstanding balance. If youre unable to pay it within the specified time typically 90 days the money will be counted as income. Youll pay income tax at your current rate as well as the 10% early withdrawal penalty if youre under 59 ½.
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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Can I Use Money From My 401 For A Down Payment
Id like to purchase a new home at the beach that will become my primary residence in about six or seven years when I retire. Im thinking of taking $200,000 from my 401 as a down payment.
Im not getting the best returns on it anyway as Ive been retired from the company and, although diversified, still not seeing any results. Im still working and contributing to another 401 and hope to have $250,000 in this when I retire. But I was always told never to touch my 401 money. What are your thoughts?
First, I am glad that you are saving for your retirement and thinking about the appropriate use of your 401. Many professionals will tell you not to take money out of a 401k for several reasons:
Requesting A Loan From Your 401
If you do not meet the criteria for a hardship distribution, you may still be able to borrow from your 401 before retirement, if your employer allows it. The specific terms of these loans vary among plans. However, the IRS provides some basic guidelines for loans that won’t trigger the additional 10% tax on early distributions.
Whether you can take a hardship withdrawal or a loan from your 401 is not actually up to the IRS, but to your employerthe plan sponsorand the plan administrator the plan provisions they’ve established must allow these actions and set terms for them.
For example, a loan from your traditional or Roth 401 cannot exceed the lesser of 50% of your vested account balance or $50,000. Although you may take multiple loans at different times, the $50,000 limit applies to the combined total of all outstanding loan balances.
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Can You Use A 401 As An Sba Loan Downpayment
Getting the money for a down payment can be one of the most challenging parts of applying for an SBA loan. However, if you have a 401 account, or another approved tax-deferred retirement account with at least $50,000 in it, you may be able to use those funds as a down payment on an SBA loan all without incurring any tax penalties. Heres how.
Using A 401k Loan For A Down Payment
take out a 401k loanwith interest. You can only take out up to $50,000 or 50% of your vested account balance, whichever is the smaller amount.no withdrawal penaltyrepay all the funds within five yearsmay not be able to contribute new funds to your 401k while paying off a 401k loanthe entire loan amount would be due at the next tax datedebt-to-income ratio
Key Takeaway You can take out a 401k loan up to $50,000 or 50% of your vested balance to pay for a down payment, but youâll have to repay the funds with interest. You may not be able to contribute new funds to your 401k while youâre paying back the loan.
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Option #2 Borrow From Yourself
This option allows you to borrow the money from your 401K, and the interest you pay typically 2 points over the prime rate also is funded to your account. The maximum you can borrow is the same amount: up to $50K or half the balance, whichever is less. The problem with this option is the whole repayment process. You have to pay the loan back usually within 5 years, so your monthly payments are going to be steep $833/month plus interest, and you have to disclose the loan and payment amount to any potential lender. This fact alone could cause you not to qualify for the mortgage loan, making the option unavailable to you. Lastly, if you leave your job for any reason, the loan amount is due in full by the time you pay taxes at the end of the year. You can ask for extensions, but it could still be a hardship. Summary of the pros and cons on this method of withdrawal are:
- PRO: You are able to get the money you need easily
- PRO: You pay back interest that goes into your own 401K account, enabling you to earn a little on the missing money until its returned
- CON: You have to pay the loan back within 5 years
- CON: You have to disclose the loan to the mortgage lender, which could have negative impacts on your loan approval
- CON: Your provider may not allow you to contribute until the loan is repaid, and you dont enjoy the same perks on taxes etc. on loan payments
- CON: If you leave your job for any reason, the loan must be repaid in full by tax time, sans any extensions
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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