Investing In Rental Properties
One interesting way to use a 401 is to purchase rental property. That is, the 401 can own the property and receive rental income tax-deferred. The 401 custodian must allow for real estate transactions. For example, self-employed individuals can use a self-directed Solo 401 to buy income property. If you buy a second home this way, you cannot live in it nor provide any services to manage or maintain the property. You, your family and certain other individuals are disqualified from occupying the home, becoming tenants in the home, or otherwise receiving any personal benefit from it. The 401 can own a mortgage on the property, as long as the mortgage is collateralized only by property and doesnt make the account owner personally liable for the loan.
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A Quick Review Of The 401 Rules
A 401 account is earmarked to save for retirementthat’s why account holders get the tax breaks. In return for giving a deduction on the money contributed to the plan and for letting that money grow tax-free, the government severely limits account holders’ access to the funds.
Not until you turn 59½ are you supposed to withdraw fundsor age 55, if you’ve left or lost your job. If neither is the case, and you do take money out, you incur a 10% early withdrawal penalty on the sum withdrawn. To add insult to injury, account holders also owe regular income tax on the amount .
Still, it is your money, and you’ve got a right to it. If you want to use the funds to buy a house, you have two options: borrow from your 401 or withdraw the money from your 401.
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How To Use A 401 Loan To Buy A House
A 401 loan is the preferredmethod if you need to cash out some of your 401 retirementfunds tobuy a house. Thats because theres a much lower cost associated with a 401loan comparedto a 401 withdrawal.
You should also know:
- A 401 loan is usually not counted in your debt-to-income ratio, so it wont hurt your chances of mortgage qualifying
- 401 loans are not reported to credit bureaus, so applying for one wont harm your credit score
Can I use my 401k to buy a house without penalty?
Unlike a 401 withdrawal, a401 loan is not subject to a 10% early withdrawal penalty from the IRS. Andthe money you receive will not be taxed as income.
The rules for using a 401 loanto buy a house are as follows:
- Your employer must allow 401loans as part of its retirement plan
- The maximum loan amount is 50% ofyour 401svested balance or $50,000, whichever is less
- The loan must be paid back withinterest , on a schedule agreed to by youand your 401 provider
- Typically,you cannot make 401 contributions while you have an outstanding 401 loan
401 loans typically need to bepaid back over five years.
However, when the money is used topurchase a home, youre usually allowed to pay it back over a longer period oftime. Rules vary by 401 company, so check with yours to learn more.
Drawbacks to 401 loans for home buying
While youre paying back the 401 loan, you usually cant make new contributions to your retirement account. And that means your employer wont be matching contributions, either.
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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The Implications Of Taking Money Out Of Your 401k
Generally, you are supposed to use your 401K for retirement. In the ideal situation, you would not withdraw the money until you were at least 59 ½ years old. In the case of a hardship, though, you can take the money out for a penalty. Right now you must pay 10% of the amount you withdraw in a penalty. You must also claim the money on your income taxes and pay the appropriate taxes on the money.
A Note About The Cares Act
Signed into law on March 27, 2020, the $2 trillion dollar Coronavirus Aid, Relief and Economic Security Act emergency stimulus bill was drafted to help those affected by the coronavirus pandemic. Under the act, 401 account owners can make a hardship withdrawal of up to $100,000 without paying the 10% penalty. The bill also grants the account holder 3 years to pay the income tax, rather than it being due within that same year.
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Alternatives To Tapping Your 401
If you must tap into retirement savings, it’s better to look at your other accounts firstspecifically IRAsespecially if you’re buying a first home .
Unlike 401s, IRAs have special provisions for first-time homebuyerspeople who haven’t owned a primary residence in the last two years, according to the IRS.
First, look to take a distribution from your IRAif you have one. You may be able to withdraw IRA contributions without penalty due to a qualified financial hardship. You can also withdraw up to $10,000 of earnings tax-free if the money is used for a first-time home purchase. As a first-time homebuyer, you can take a $10,000 distribution without owing the 10% tax penalty, although that $10,000 would be added to your federal and state income taxes. If you take a distribution larger than $10,000, a 10% penalty would be applied to the additional distribution amount. It also would be added to your income taxes.
You Can Also Borrow From Your 401 But There Are Downsides
According to Quicken Loans, you can often borrow from your 401generally up to 50 percent of your vested account balance or $50,000, whichever amount is lessalthough the company advises checking with your employer or HR department to determine whether your 401 plan even allows loans.
The company also notes that youll have an allotted time for repaying the loan, which is usually within five years. Youll pay interest on the loan, which is often 2 points over the prime rate. The loan might impact your debt-to-income ratio and make it harder to get a mortgage.
However, there are upsides. Quicken Loans said, Besides allowing you to make a purchase you might otherwise not be able to make, borrowing from your 401 is basically borrowing from yourself, rather than another lender. That means that you might not be losing as much money on interest payments as you would if you got the funds via another means.
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Borrow Against Your 401
Borrowing from your 401 is generally the more advantageous option if you want to tap your plan for a down payment.
If your employers plan allows employees to take out loans against their 401 accounts, youll typically be able to borrow up to 50% of your vested account balance or $50,000, whichever is less.
Tip:
Youll then have to make more or less equal payments at least quarterly, with interest until youve repaid the loan. Youll typically need to repay it within five years.
Upsides
- Wont affect your credit
Downsides
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When A 401 Loan Makes Sense
When you mustfind the cash for a serious short-term liquidity need, a loan from your 401 plan probably is one of the first places you should look. Let’s define short-term as being roughly a year or less. Let’s define “serious liquidity need” as a serious one-time demand for funds or a lump-sum cash payment.
Kathryn B. Hauer, MBA, CFP®, a financial planner with Wilson David Investment Advisors and author of Financial Advice for Blue Collar America put it this way: “Lets face it, in the real world, sometimes people need money. Borrowing from your 401 can be financially smarter than taking out a cripplingly high-interest title loan, pawn, or payday loanor even a more reasonable personal loan. It will cost you less in the long run.”
Why is your 401 an attractive source for short-term loans? Because it can be the quickest, simplest, lowest-cost way to get the cash you need. Receiving a loan from your 401 is not a taxable event unless the loan limits and repayment rules are violated, and it has no impact on your .
Assuming you pay back a short-term loan on schedule, it usually will have little effect on your retirement savings progress. In fact, in some cases, it can even have a positive impact. Let’s dig a little deeper to explain why.
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Which Option Should You Choose
The option that is best for you depends on what your goals are and which downsides you are willing to deal with, as both options have downsides.
The biggest downside of 401 loans is that they have to be paid back. The biggest downside of 401 withdrawals is that you will take a massive tax hit. If your top priority is to prevent losing a lot of money, then you should consider going with the 401 loan.
However, if your top priority is to not have to pay back any money that you take out, then you should go with the 401 withdrawal.
Regardless of which option you take, your 401 will still take a big hit, at least temporarily. Removing any money invested in a tax-deferred retirement plan will prevent you from earning the compound interest that you gain if you leave the money in your 401.
Alternatives To Borrowing From Your 401
Before you borrow from a 401 to buy a home, consider whether there are other options available. For example:
- Down payment assistance programs: Down payment assistance programs are designed to help eligible buyers with down payment and closing costs. Some programs offer grants to qualified buyers that don’t have to be repaid. Others offer matching savings programs, similar to a 401, that match every dollar you save towards your down payment, up to a certain amount.
- Down payment gifts: If you have family members who want to support your efforts to buy a home, consider asking them to gift money for a down payment. The amount of money that can be gifted and the amount you have to put towards the down payment out of your own funds may vary based on the type of mortgage. The most important thing to remember with down payment gifts is that they must be thoroughly documented. Otherwise, the lender might not allow you to use those funds for your down payment.
- IRA withdrawal: If you have an IRA, you can withdraw up to $10,000 from your account towards a down payment on a home without incurring the 10% early-withdrawal penalty. Be aware that if you’re withdrawing from a traditional IRA, you’ll still owe income tax on the amount you withdraw.
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How To Use A 401 For A Home Down Payment
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 25% 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.
How To Buy Land With Your 401k Or Ira
- Ray Seaman
If youre like most people, you probably think the only thing you can buy with your 401k or IRA are stocks, bonds, ETFs, and mutual funds. Its a walled garden stocked and carefully maintained by whoever your brokerage is Fortunately, thats not the case. You can venture outside the walled garden and invest in things like real estate, including land. Its one of personal finances best kept secrets: the self-directed retirement account .
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Hows Your Financial Health
Before clicking through pages of online listings or falling in love with your dream home, do a serious audit of your finances. You need to be prepared for both the purchase and the ongoing expenses of a home. The outcome of this audit will tell you whether youre ready to take this big step, or if you need to do more to prepare. Follow these steps:
Look at your savings. Dont even consider buying a home before you have an emergency savings account with three to six months of living expenses. When you buy a home, there will be considerable up-front costs, including the down payment and closing costs. You need money put away not only for those costs but also for your emergency fund. Lenders will require it.
One of the biggest challenges is keeping your savings in an accessible, relatively safe vehicle that still provides a return so that youre keeping up with inflation.
Review your spending.You need to know exactly how much youre spending every monthand where its going. This calculation will tell you how much you can allocate to a mortgage payment. Make sure you account for everythingutilities, food, car maintenance and payments, student debt, clothing, kids activities, entertainment, retirement savings, regular savings, and any miscellaneous items.
Alternatives To Using A 401 For A Home Purchase
You may not need a 401 loan or withdrawal to begin with. If your mortgage lender allows it, you can make adown payment of less than 20%. While a 20% down payment is standard, you only have to pay your minimum down payment. If your down payment is less than 20%, you get charged monthlyPrivate Mortage Insurancepremiums until you own 20% of your homes equity. Generally, paying for these premiums is better than taking money from your 401.
Before using your retirement funds to pay for a down payment, consider any alternatives you have available:
1. Savings and Investment Accounts
Check any liquid assets you have available. Before getting a mortgage, make sure your income supports themonthly mortgage paymentsand that you have savings for emergencies. Checkhow much house can i afford calculatorto help you determine your affordability.
2. Federal and State Government First-Time Home Buyer Programs
The federal government has manyfirst-time home buyer programswith lower minimum down payments and down payment assistance programs. You should also check with your states local housing authority because each state has unique first-time home buyer programs.
3. Family and Friends
Getting a family gift can help you secure a down payment without having to take on unnecessary debt or compromise your retirement funds. This family gift cannot be a loan.
4. Personal Loans
5. IRA
6. 401 Loan or 401 Withdrawal
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Using Your 401 To Buy A Home
For many prospective home buyers, getting funds for a down payment and closing costs can sometimes be a difficult task. In fact, most people would say that their biggest barrier to purchasing a home is the ability to bring tens of thousands of dollars to the table.
This can lead to buyers accessing a retirement account as a way to provide funds for buying and While this is allowed, there are some factors and drawbacks that you might want to consider.
Another Tool In Your Financial Toolbelt
Your SDIRA is yet another tool you have to diversify the way you save and invest. As Ive said in previous articles, land is a great asset to buy and invest in alongside your traditional savings and investments. When it comes to retirement, the same idea applies, and I do practice what I preach. I have a Traditional IRA that is invested in the stock market with basic index funds. I have a self-directed Roth IRA that I use to buy and sell land. I havent abandoned the traditional retirement account and mutual funds, but Im not 100% dependent on it either. I like having more than one option, and I suspect thats going to be the case with most people who read this.
If youve had some experience with real estate or buying land, and its an investment youre comfortable with, an SDIRA is something you should think about. Even if youre on the fence about an SDIRA, you can always reach out to a custodian. Theyre happy to answer your questions, and get you started once youre ready.
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