Consider Using Your Savings And Investments
Taking out a loan to help cover the expense of a down payment and closing costs is more expensive than covering these costs out-of-pocket. If you have the money to pay in your savings account or can liquidate investments like stocks or bonds, you should consider covering the costs without a loan to avoid paying any fees or penalties.
Borrowing From Your 401 To Buy A House
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.
How Can I Avoid Paying Early Withdrawal Penalty
401 is designed in a way that discourages the account holders from withdrawing the funds prematurely by setting a 10% fee on the withdrawals as well as levying an income tax on the withdrawn funds. These fees make it very expensive to withdraw money from a 401 account. Of course, there is a way to avoid withdrawal penalties, but they are available to people who are at least 59 and a half years of age. It may be impossible to avoid the prepayment penalty if you are younger than 59 and a half years old and you choose to withdraw cash from the account.
It might be possible to get the funds sitting in the account by loaning them to yourself. This is a valid way to get some cash, but it cannot be considered a withdrawal mainly because you will have to pay it back to your account. If you fail to pay back a portion of the loan, you will be given early withdrawal penalties as well as income tax on the outstanding balance.
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What Are The Rules & Penalties For Using 401 Funds To Buy A House
Heres a side-by-side look at some key differences between taking out a 401 loan and withdrawing funds from a 401.
| 401 loans | 401 withdrawals |
|---|---|
|
Must be repaid with interest in a certain period of time usually 5 years. Qualified loans are penalty free and tax free, unless the borrower defaults or leaves their job before closing the loan. The maximum loan amount is 50% of the vested account balance, or $50,000, whichever is less. Interest accrued on the loan goes back into the 401, so the borrower is basically paying interest back to themselves. The interest is also tax-deferred until retirement. If the borrower doesnt repay the loan on time, the loan is treated as a regular distribution and subject to taxes an early withdrawal penalty of 10%. |
Do not have to be repaid. Usually allowed only in the case of financial hardship, which can include medical expenses, funeral expenses, and primary home-buying expenses, if the individual meets strict IRS criteria for hardship. Subject to income tax and a 10% early withdrawal penalty for people under age 59½. One can only withdraw enough to cover the immediate expense , with a limit of 50% of the vested balance or $50,000whichever is less You can only withdraw enough to cover the immediate expense , with a limit of 50% of the vested balance or $50,000 whichever is less. |
Don’t Forget About The 60 Day Rollover Option
Another IRA withdrawal strategy that is used as a bridge solution is a 60 Day Rollover. The 60 Day Rollover option is available to anyone with an IRA that has not completed a 60 day rollover within the past 12 months. If you are under the age of 59.5 and take a withdrawal from your IRA but you put the money back into the IRA within 60 days, its like the withdrawal never happened. We call it a bridge solution because you have to have the cash to put the money back into your IRA within 60 days to avoid the taxes and penalty. We frequently see this solution used when a client is simultaneously buying and selling a house. Its often the intent that the seller plans to use the proceeds from the sale of their current house for the down payment on their new house. Unfortunately due to the complexity of the closing process, sometimes the closing on the new house will happen prior to the closing on the current house. This puts the homeowner in a cash strapped position because they dont have the cash to close on the new house.
As long as the closing date on the house that you are selling happens within the 60 day window, you would be able to take a withdrawal from your IRA, use the cash from the IRA withdrawal for the closing on their new house, and then return the money to your IRA within the 60 day period from the house you sold. Unlike the first time homebuyer exemption which carries a $10,000 limit, the 60 day rollover does not have a dollar limit.
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Withdraw From Your Ira
While using a 401 for a down payment may be costly at tax season, theres a good chance you might have better luck taking a distribution from an IRA instead. In this case, the rules around distributions depend on what kind of IRA you have. For example, if youre withdrawing from a Roth IRA, you can take a tax-free distribution at any time , provided that youve had the account for at least five years.
With a traditional IRA, however, the rules are a little bit different. Here, the tax scenario works similarly to a 401, where your distributions are taxed as ordinary income and youre typically taxed on early withdrawals. However, there is an exception for first-time homebuyers: They are allowed to borrow up to $10,000 to put towards their down payment without having to pay the extra 10% early distribution tax.
Get A Gift From A Loved One
Another alternative to using a 401 to buy a house is to ask for a gift from a loved one. Gift money can be used for a down payment as long as the lender can verify the source of the funds and the person giving the gift submits a statement that says the money is truly a gift and not a loan.
While parents typically give their children gifts, depending on your loan program, the gift may be able to come from another source. For instance, Fannie Mae allows gift funds to come from an immediate family member, fiancé or domestic partner, while the FHAs list includes family members, employers, close friends and charitable organizations, as well as organizations or agencies providing homeownership assistance.
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Does A 401 Loan Or Withdrawal Make More Sense
When you consider the potential tax consequences associated with an early withdrawal, a 401 loan may seem more attractive. Of course, there’s one drawback with both options: you’re diminishing your retirement savings.
With a 401 loan, you’d have the ability to replace that money over time. If you’re cashing out an old 401, however, there’s no way to put that money back. In both cases, you’re missing out on the power of compound interest to grow your retirement wealth over time.
One upside of deciding to borrow from a 401 for a housewhether you take a loan or make a withdrawalis that it may allow you to avoid paying private mortgage insurance if you offer the lender a large enough down payment. Private mortgage insurance protects the lender, and it’s typically required if you’re putting less than 20% down on a conventional mortgage. Private mortgage insurance can be eliminated when you reach 20% equity in the home, but it can add to the cost of homeownership in the early years of your mortgage.
What To Consider Before Making A 401 Withdrawal
In most circumstances, with an early withdrawal, youll face a 10% fee on any amount you withdraw. For example, if you withdraw $10,000, youll pay a $1,000 fee. Along with the fee, youll need to pay income tax on whatever you withdraw from your 401. So, if you face a 20% income tax on top of the early withdrawal fee, your $10,000 withdrawal just becomes $7,000.
The other thing to consider is the opportunity cost of withdrawing from your 401. In other words, what will that cost you in retirement if you pull out money now to make a down payment? Lets work out an example with our 401 calculator.
Say you pull out $10,000 from your 401 at age 35. Assuming a conservative annual return rate of 4%, that $10,000 will be $33,731 by the time you turn 66. In 31 years, that money more than tripled, earning you $23,731 just by sitting in your 401.
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What Is A 401 & How Does It Work
401s are retirement plans offered by many employers across the United States they provide employees with a unique opportunity to grow wealth over long periods of time. In their simplest form, 401s are personal accounts where employees may deposit money and grow savings earmarked for retirement. At their pinnacle, however, 401s are one of the best ways for employees to both shelter taxes and generate long-term profits.
In order to fully understand 401s and how they work, its best to start at the beginning. Consequently, these plans were put in place by the U.S. government and included in the Internal Revenue Services tax code regulations to encourage employees to save for retirement. In doing so, participating employers will allow qualified employees to transfer a portion of each paycheck into the retirement account each year.
The money is deducted from the employees gross income, which means it hasnt been taxed yet. As a result, contributions actually detract from the employees taxable income and lessen the tax burden each year by the total amount placed into the account. In other words, employees will be taxed less because the IRS doesnt count the contributions towards their total income.
What Is A 401 Withdrawal
A 401 withdrawal liquidates some or all of an employees retirement account and pays it out as cash.
The employee is not obligated to repay or replace the cash withdrawn from the 401 account, but the IRS will recapture 10% of the amount withdrawn as part of the years federal tax filing. Money withdrawn may also count the withdrawal as taxable income.
Employees may continue to make 401 contributions after a withdrawal until annual contribution limits are reached.
Ask an accountant about the tax implications of withdrawing money from your 401 to make a down payment or purchase a home.
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Can I Use My 401 To Buy A House
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For many would-be homeowners, the down payment is the biggest entry barrier to buying a house. While down payments can be as low as 3.5%, 20% is ideal if you want to secure a mortgage without monthly mortgage insurance fees.
If youre having trouble gathering funds for a down payment, you might find yourself considering using your 401 retirement fund as a convenient source of cash. While this is technically allowed, and could help you cover your down payment, it shouldnt be your first choice. There are some factors and drawbacks that you might want to consider before using your 401 to buy a house.
Well break down the pros and cons of making a 401 withdrawal for a home purchase, as well as some alternatives.
Choose An Ira Provider
Step one is deciding where you want your money to go. If you already have an IRA and would like to roll your funds over into that account, you can skip to step 3. Otherwise, youll want to spend some time researching different brokerages and retirement account products. Important factors to benchmark include minimum balance requirements, investments, and customer service options. Bankrate.com offers the latest reviews of the top brokerages so that you can make some comparisons.
Again, only first-time home buyers can withdraw from their IRA accounts without penalty. Further, that is only if the funds are being used to purchase a home. If you arent a first-time homebuyer and want to invest in real estate, research self-directed IRA providers. You would then be able to withdraw funds to invest in real estate without penalty. Remember the important caveat that the real estate purchase cannot be for personal use.
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Alternatives To Using Your 401 To Buy A House
Even if youre short on cash and facing hardship, there are other options you might want to consider before tapping into your 401 account to cover the down payment on a house.
IRA Account
If you have an IRA, you should look there for extra funds before considering an early withdrawal from your 401. IRAs are built with special provisions for first-time home buyers, which the IRS defines as anyone who hasnt owned a primary residence within the previous 2 years.
Under these provisions, first-time home buyers are allowed to withdraw up to $10,000 without incurring the 10% penalty. However, that $10,000 is still subject to state and federal income taxes. If your withdrawal exceeds $10,000, then the 10% penalty is applied to the additional distribution.
A Roth IRA is an even better option, if you have one. Some plans allow you to make a hardship withdrawal, and up to $10,000 can be withdrawn tax-free for the express purpose of a first-time home purchase.
FHA Loan
A Federal Housing Administration loan is a government-backed mortgage with looser requirements designed to make it easier for first-time home buyers to purchase a property. This includes low down-payment options and lower credit score requirements. For this reason, an FHA loan may be a better option than making a withdrawal from your 401.
- Size of your down payment
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 You Make A 401 Withdrawal To Buy A Home
Whether you can make a 401 withdrawal for a home purchase depends on your age and plan. If youre less than age 59.5, this withdrawal is an early withdrawal. The rules around early withdrawals will be outlined in your 401 plan. For instance, your employer may require extra documentation for you to make a case for the withdrawal.
You may have also heard that you can make a 401 hardship withdrawal to buy a house. This isnt true. The benefit of a hardship withdrawal is that it waives the early withdrawal fee. While this is an option if you become disabled or have medical expenses, the IRS explicitly says its not an option for home buying.
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Historyand Limitationsof The 401
The origins of the 401 plan can be traced to the Revenue Act of 1978, which included a provisionSection 401that gave workers a tax-free way to defer compensation from bonuses or stock options. The law went into effect in 1980.
A year later, the Internal Revenue Service issued rules allowing employees to contribute to their 401 plans through salary deductions, which led to the widespread rollout of 401 plans in the early 1980s. Today, 401 plans hold more than $28 trillion in assets, while traditional pensions, at least in the private sector, are increasingly rare.
Section 401 allowed account holders to receive a deduction on the money they invest into the plan and watch their contributions grow tax-free. The main intent of creating 401 accounts was to provide an incentive for employees to save for retirement.
Alas, U.S. Treasury regulations put a few limits on our ability to access those funds for day-to-day monetary needs. For example, you cant withdraw funds until you reach age 59½ . If neither is the case, and you decide to take money out, you will trigger a 10 percent early withdrawal penalty on the amount withdrawn. In addition, 401 holders must pay regular income tax on the withdrawal, just as with any distribution from the account, whatever their age.
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