What Happens If You Use Your 401 To Buy A House
Your 401 might be your largest asset, making it a tempting source of funds for your down payment but going this route isnt usually recommended.
Amy FontinelleUpdated June 2, 2021
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Saving up for a down payment can be a major hurdle to homeownership, especially since it isnt the only expense in the mortgage process. You might need to come up with money for closing costs, moving costs, and modifications or furnishings for your new home as well.
If youre short on cash, one way you can fund your down payment is to draw from your 401. However, this comes with significant drawbacks.
Heres what you need to know about using your 401 for a home down payment:
Alternatives To Using Your 401
Can I use a 401 to buy a house? is never your only option. Even if you dont have a large amount of savings apart from your retirement fund, that doesnt mean you cant find an alternative for paying for a home.
For those who just dont have the cash upfront to purchase a home, there are many loan options available. No matter your current circumstances, there is a way to get the financial help needed for purchasing a home.
It is important to do research on loan options, as some loans have friendlier terms than others. For example, you may find that a fixed mortgage loan will have you paying less in the long term than an FHA loan. For some, they may even find out that withdrawing from their 401 is the best option after all.
Speak with a professional loan advisor to learn more about comparing terms, interest rates, and outcomes. They will help you determine what will work the best for your current financial circumstances.
Should You Use A 401 Loan To Pay Off Your Credit Cards
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Many 401 plans allow users to borrow against their retirement savings. Its a relatively low-interest loan option that some people use to consolidate credit card debt meaning, taking a more favorable loan to pay off several high-interest credit card balances. But NerdWallet cautions against taking a 401 loan except as a last resort.
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What Happens If You Leave Your Job
When you take out a loan from a 401, you may have no intention of leaving your current employer. But if you receive a better job offer, or are laid off or otherwise leave, you could be required to pay the loan back in full or face some serious tax consequences.
Employees who leave their jobs with an outstanding 401 loan have until the tax-return-filing due date for that tax year, including any extensions, to repay the outstanding balance of the loan, or to roll it over into another eligible retirement account. That means if you left your job in January 2020, you would have until April 15, 2021 when your 2020 federal tax return is due to roll over or repay the loan amount. Prior to the Tax Cuts and Jobs Act of 2017, the deadline was 60 days.
If you cant repay the loan, your employer will treat the remaining unpaid balance as a distribution and issue Form 1099-R to the IRS. That amount is typically considered taxable income and may be subject to a 10% penalty on the amount of the distribution for early withdrawal if youre younger than 59½ or dont otherwise qualify for an exemption.
Unfortunately, this worst-case scenario isnt rare. A 2014 study from the Pension Research Council at the Wharton School of the University of Pennsylvania found that 86% of workers in the sample who left their jobs with a loan outstanding eventually defaulted on the loan.
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.
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Advantages Of Borrowing From A 401
Borrowing from your 401 isnt ideal, but it does have some advantages especially when compared to an early withdrawal.
A loan allows you to avoid paying the taxes and penalties that come with taking an early withdrawal. Additionally, the interest you pay on the loan will go back into your retirement account, although on a post-tax basis.
401 loans also wont require a credit check or be listed as debt on your credit report. If youre forced to default on the loan, you wont have to worry about it damaging your credit score because the default wont be reported to credit bureaus.
Or Ira Retirement Income
If you draw money each month from a 401, Roth IRA, traditional IRA or another retirement account, your lender will consider these dollars as part of your income. An IRA withdrawal, then, will boost your qualifying income. Your lender might request that you send in a copy of your most recent retirement account statement so that it can verify how long youll receive these monthly withdrawals.
Read Also: Can I Move Money From 401k To Roth Ira
Early Withdrawals Less Attractive Than Loan
One alternative to a 401 loan is a hardship distribution as part of an early withdrawal, but that comes with all kinds of taxes and penalties. If you withdraw the funds before retirement age youll typically be hit with income taxes on any gains and may be assessed a 10 percent bonus penalty, depending on the nature of the hardship.
You can also claim a hardship distribution with an early withdrawal.
The IRS defines a hardship distribution as an immediate and heavy financial need of the employee, adding that the amount must be necessary to satisfy the financial need. This type of early withdrawal doesnt require you to pay it back, nor does it come with any penalties.
A hardship distribution through an early withdrawal covers a few different circumstances, including:
- Certain medical expenses
- Some costs for buying a principal home
- Tuition, fees and education expenses
- Costs to prevent getting evicted or foreclosed
- Funeral or burial expenses
- Emergency home repairs for uninsured casualty losses
Hardships can be relative, and yours may not qualify you for an early withdrawal.
This type of withdrawal doesnt require you to pay it back. But its a good idea to avoid an early withdrawal, if at all possible, because of the serious negative effects on your retirement funds. Here are a few ways to sidestep those hefty levies and keep your retirement on track.
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.
Recommended Reading: What Do I Do With 401k When I Retire
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.
What Are The Risks And Costs Of Refinancing
Make sure you factor in fees before you decide if refinancing is right for you. You need to pay appraisal costsOpens a popup., legal fees and possible prepayment charges. If you switch lenders, you may have to pay a discharge fee. Also, be aware that taking out home equity comes with risks. For example, if you switch from a fixed-rate mortgage to a variable-rate mortgage, you may deal with rising interest rates and higher monthly payments in the future.
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What Is The Interest Rate On A 401k Loan
The interest rate on a 401k loan is typically one or two points higher than the prime rate. The prime rate sits at 3.25% as of March 2021, so you can expect the interest rate on a 401k loan to be around 4.25% to 5.25%. Unlike most loans, the interest rate on a 401k loan isn’t impacted by your credit, which is why some borrowers prefer these loans.
Qualifying Based On Income
The most common way for retirees to get a mortgage is by qualifying based on income, said certified financial planner Daniel Graff, a principal and client advisor at Sullivan, Bruyette, Speros & Blayney in McLean, Virginia.
Lenders generally will look at your last two years’ worth of tax returns to see what that amount is. It may include, for instance, Social Security, pension income, dividends and interest.
However, your taxable income may not be enough to qualify for the loan on its own. That’s where a retirement account like a 401 plan or individual retirement account can come into play.
“You basically create more cash flow to satisfy the lender,” said CFP David Demming, president of Demming Financial Services in Aurora, Ohio.
The idea is that you take distributions to help you qualify for the mortgage, even if you don’t really need the money. As long as you’re at least age 59½, you can tap your IRA or 401 plan without paying a 10% early-withdrawal penalty.
And, under rollover rules applying to retirement accounts, you can put the cash back within 60 days without the distributions being taxable. Beyond that time frame, however, the withdrawals would be locked in and you’d owe income taxes on the money.
Meanwhile, the lender would see the income on your bank statements, where the money came from and when it hit your account.
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The Size Of Your Mortgage
The point above doesnt mean you shouldnt consider the numbers. The value of your mortgage at retirement could make a huge difference in your payoff plan.
You also need to understand your current tax situation and how taking distributions from your retirement accounts to pay off debt could cause you to change tax brackets and pay more tax than you would otherwise, Poorman says.
If youre retired, any pre-tax money taken out of your 401 is treated as income. So, for example, taking $100K out of your retirement plan to pay off your mortgage could easily bump you up into a higher tax bracket . A balance of $10K probably wont have as large of an impact.
Taking $100K out of your retirement plan to pay off your mortgage could bump you up into a higher tax bracket . A balance of $10K probably wont have as large of an impact.
If you continue to make monthly mortgage payments, the amount of interest you pay may be tax deductible. But that interest needs to be fairly high to make it count. The 2017 Tax Cuts and Job Acts nearly doubled the standard deduction, eliminating itemized deductions, such as mortgage interest, for many Americans.
Protect your mortgage.
If you choose to take your house payments with you in retirement, life insurance provides a form of mortgage protection. With a term insurance policy you can align the length of the term with the length of your mortgage.
Look Into Down Payment Assistance Programs
If you dont want to use a 401 for your down payment, you can always look into down payment assistance programs. These programs are meant to help buyers with low-to-moderate incomes shoulder the burden of paying their down payment and closing costs. Programs like these are typically available on a federal or state level, though sometimes they can be made available at the municipal level as well.
Often, the assistance will come in the form of a forgivable grant, a low-interest or deferred-payment loan or simply a second mortgage. However, each down payment assistance program is different, so if youre thinking of going this route, your best bet is to talk to a lender in your area who can give you an overview of your options.
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Can I Use 401 Funds To Build A House
Refinancing your mortgage to a lower interest rate can save you thousands of dollars over the life of the loan. However, if you don’t have the money to pay for the closing costs, or if you have seen your home’s value fall to the point where you owe more than it’s worth, you might miss out on the opportunity to save money with a refi. Before you give up hope, consider the options your 401 might provide in helping to refinance your home.
Make A Withdrawal From Your 401
A withdrawal is generally a worse option when it comes to tapping a 401 for a down payment.
If your employers plan allows for hardship distributions, the IRS allows individuals to take early withdrawals before age 59½ as a result of an immediate and heavy financial need, such as buying a home.
While buying a home might not sound like a hardship, thats how the IRS regulates these types of distributions.
You wont have to or even be allowed to repay the money you take out. Youll pay regular income tax on the amount withdrawn, and if youre younger than 59½, youll also owe a 10% early withdrawal tax penalty.
Upsides
- Doesnt have to be repaid
- Wont affect your debt-to-income ratio
Downsides
- Taxes and the 10% early withdrawal penalty reduce the amount available to put toward your home
- Permanently reduces your retirement savings
Recommended Reading: How Does A 401k Work When You Change Jobs
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.
Example:
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.
Learn More: How to Save for a Down Payment on a House
