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.
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.
Furthermore, 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 The withdrawal is considered income, so you will pay federal and state taxes on the amount withdrawn.
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Alternatives To Taking Out A 401 Loan For A Home
Choosing a more affordable home that requires a lower down payment is obviously an option. Further, you could wait to purchase the home until you can save up for the down payment, although the house you set your sights on may not still be on the market. If neither of these options are palatable to you, it’s time to consider alternative financing, of which there is plenty.
Perhaps the easiest is to see if you can get a Federal Housing Administration loan or a U.S. Department of Agriculture loan. FHA loans require only 3.5% down, and USDA loans don’t require any money down. However, you’ll have to pay private mortgage insurance until you reach 20% equity in your home. Veterans Affairs loans are also worth considering if you are serving or have served in the military.
If you are determined to buy the home now, you may be better off borrowing from your IRA, if you have one, than your 401. First-time home buyers can borrow up to $10,000 without paying an early distribution penalty, although the amount will be added to your income tax this year, unless it comes from a Roth account which is post-tax. But while the consequences might be slightly less severe than borrowing from a 401, you’re still losing out on the compound interest that would have been earned from leaving that money in the IRA.
Tapping Your 401 May Indicate A Bigger Financial Issue
Some might justify tapping into their 401 as a way of getting just a few more dollars to afford that down payment, but according to Steve Landersman, a financial planner, what they don’t realize is that they aren’t prepared for so many other costs.
“The main reason I’m opposed to people tapping into their IRA or 401 plans for a home purchase is that it shows they don’t have the reserve savings necessary to be a homeowner,” says Landersman. “Just buying the house is the first step, there are always unexpected expenses and improvements.”
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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.
How To Buy Your Dream House With Your Eyes Wide Open
For many, property and the American dream are inextricably linked its a huge milestone on the path to success and security. If youre looking to buy a house, its important to go into the process with as much information as possible. That way, you can strut confidently towards your own slice of the American dream.
If you dream of owning a home, well be the last to persuade you otherwise. But it shouldnt come at the expense of your financial security. Here are a few things to look at as you pursue home ownership.
A 401 Loan Vs Mortgage Insurance
Lets look at two possible scenarios for a purchase of a $300,000 home.
Suppose you have $15,000 in cash for a down payment. You have a credit score of 700. If you take out a mortgage at $285,000 at 5 percent interest, your monthly payment will be $1,530. But with a loan to value ratio of 95 percent, your monthly mortgage insurance cost will be around $220. Your total monthly obligation would be $1,750. This would be the payment for the first five years, until the mortgage insurance dropped off.
If you have a 401 worth at least $90,000, you can borrow up to 50 percent of it. This allows you to only take a mortgage loan of $240,000 and avoid mortgage insurance. The mortgage payment would be $1,288. In this scenario, your 401 loan will be for $45,000.
If your 401 loan is also at 5 percent interest, on a typical five year repayment, your payments to yourself will be $850. This makes for a total monthly payment in the first five years of $2,138. While this is significantly higher than in the mortgage insurance scenario, remember that the $850 is coming straight back to you. After the five years, your monthly payment for the remaining 25 years would be almost $250 less than in the first scenario.
Are There Other 401 Options
Withdrawal is not the only way to access 401 funds for a down payment.
Your benefits provider may also offer 401 loan options. If available, this option not only helps you avoid the early withdrawal penalty fee, but also paying income tax on your withdrawal.
401 loans let you borrow up to 50% of your vested account balance Taking out this type of loan puts your 401 account on hold for the duration of the loan you wont be able to make additional contributions until the money is paid back.
But how can you calculate whether the 401 loan is a smart financial decision? As with any lending scenario, the price you pay to borrow the money has a big impact on determining whether the loan is worth it. You can typically expect a 1%-2% spike above the prime rate for these types of loans. Another factor to consider has to do with your employment. If youre unable to pay back the loan on time or before leaving/losing your job, you may be subject to the same financial penalties that come with a withdrawal.
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Pros And Cons Of Using A 401 To Buy A House
Here are the pros and cons of using a 401 to buy a home, at a glance:
|Pros of Using a 401 to Buy a House||Cons of Using a 401 to Buy a House|
|Individuals may be able to purchase a home that they might otherwise not be able to afford.||Individuals cant make regular contributions to their 401 while making loan payments.|
|When using a 401 loan, individuals are borrowing money from themselves, so they dont owe interest to a bank or other institution.||Borrowed or withdrawn funds arent growing inside the 401 account, potentially derailing an individuals retirement savings.|
|Interest rates are generally low.||If a person doesnt qualify for a hardship withdrawal and theyre under age 59½, withdrawals would be subject to income tax and a 10% early withdrawal penalty.|
|You dont have to meet any credit requirements.||If a person leaves their job before the loan is repaid, the balance owed could be deducted from the remainder of their 401 funds as an offset. For those under 59½, the amount of the offset would be considered a distribution and the borrower would owe taxes and a 10% penalty .|
Should You Borrow From Your 401 To Make A Home Down Payment
by Christy Bieber | Updated July 19, 2021 – First published on June 17, 2021
Many or all of the products here are from our partners that pay us a commission. Its how we make money. But our editorial integrity ensures our experts opinions arent influenced by compensation. Terms may apply to offers listed on this page.
You may regret making the choice to raid your retirement funds.
When you’re trying to buy a home, it’s best to make a 20% down payment. Doing so allows you to avoid having to buy private mortgage insurance . PMI ensures lenders don’t end up with out-of-pocket losses if they have to foreclose. Unfortunately you cover the expenses of PMI, although it provides you with no personal protection.
A 20% down payment is also useful because it:
- Makes it easier to get approved for a home loan
- Allows you to borrow less
- Saves you money on interest over time
- Makes it less likely you’ll end up owing more than your home is worth
Unfortunately, coming up with 20% down can be difficult for many home buyers. And, in fact, even finding the money for a smaller down payment can be a challenge if you’re in an expensive market.
If you decide now is a good time to buy a home but struggle to come up with the cash to make a down payment, you may be tempted to borrow against your 401. After all, if you have a lot of money sitting in this account, it may seem like an attractive source of funds that could solve your down payment issues.
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Using A 401 Withdrawal To Buy A House
401 withdrawals are generallynot recommended as a means to buy a house because theyresubject to steep fees and penalties that dont apply to 401 loans.
If you take a 401 withdrawalbefore age 59½, youll have to pay:
- A 10% early withdrawal penaltyon the funds removed
- Incometax on the amount withdrawn
For example, say you withdraw$20,000 from your 401 to cover your down payment and closing costs.
- Youll be charged a $2,000 earlywithdrawal penalty
- Andyoull have to pay income tax on the $20K, which likely comes out to around$4,000-$6,000
Thats up to $8,000gone from your retirement savings, on top of the initial withdrawal.
The standard rules for 401withdrawals are as follows:
- Most 401 plans allow withdrawals only in cases of financial hardship
- However, using the money to buy a primary residence often qualifies as a hardship withdrawal
- You can withdraw only the money required to cover your immediate need
- The money does not have to be repaid
Since the IRS considers 401 withdrawals income,withdrawing 401 money could bump some home buyers into a higher tax bracket.This could add even more to the cost of the early withdrawal.
The CARES Act provision allowingfor tax-free withdrawals from a 401 expired on Dec. 31, 2020. The IRSsnormal 10% penalty is being enforced on hardship withdrawals in 2021.
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.
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There Is More Than One Way To Tap Into Your 401 To Help With A Down Payment For A House
If your plan allows, you can withdraw the funds in your 401 through what is known as a hardship distribution. Keep in mind that these types of withdrawals arent required by law, so many plans dont even allow them. However, if yours does, it can be an option to liquidate your account. Youll need to require an immediate and heavy need for the funds, per the IRS. Fortunately, the IRS deems purchasing a principal residence an immediate and heavy need, making this an exception. And there is no cap on this type of withdrawal, so you can take out as much as you need to cover the costs.
Another option for accessing the funds in your 401 is to borrow the money . Certain conditions must be met in this case, however. For example, the loan has to carry a reasonable interest rate. Also, the loan cant exceed 50% or $50,000 of the accounts vested value, whichever is less. If you have less than $10,000 in your account though, you may borrow the account in its entirety.
Tax Treatment Of Roth Ira Distributions When Used For A Home Purchase
Money that you contribute to a Roth IRA can come back out of the account at any time, free from tax and penalty.
In addition, a distribution of earnings is free from the 10% penalty if it is a qualified first-time homebuyer distribution. And if you have satisfied the 5-year rule, the distribution will be free from regular income tax as well.
For a distribution to be a qualified first-time homebuyer distribution:
- It must be used within 120 days of the distribution
- to pay qualified acquisition costs
- on a principal residence
- for a first-time homebuyer.
- And the homebuyer in question must be yourself, your spouse, one of your ancestors, or one of your descendants.
- Also, qualified first-time homebuyer distributions are limited to $10,000 over your lifetime.
As far as definitions:
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