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.
Mortgage Interest Tax Strategy
Keep in mind that youll be deducting mortgage interest on your taxes after you purchase your home. This may actually wash with some or all of the income you report from a retirement account withdrawal.
For example, lets say you withdrew $25,000 from your 401k and paid $25,000 in mortgage interest the same year. The $25,000 youll report in additional income will wash with the $25,000 mortgage interest deduction. In other words, your taxable income wont be increased by the withdrawal, and you will effectively pay no tax on it.
However, you will still be liable for the 10% penalty, which is $2,500 in this case. This type of strategy can work for IRA, SIMPLE, and SEP withdrawals as well, but you wont be liable for the 10% penalty unless you withdraw more than $10,000.
Make A 401 Withdrawal
Your second option would be to make a direct withdrawal from your 401 account. As mentioned above, this is the less desirable of the two options.
An early withdrawal would be classified as a hardship withdrawal. The IRS considers any emergency removal of funds from a 401 to cover an immediate and heavy financial need as a hardship withdrawal. Whether or not the purchase of a home using your 401 counts as a hardship withdrawal is a determination that falls to your employer, and you will need to present evidence of hardship before the withdrawal can be approved.
Regardless, you will still likely incur the 10% early withdrawal penalty. There are exemptions in place for specific circumstances, including home buying expenses for a principal residence. Qualifying for such exemptions is difficult by design, however. If you possess other assets that could be used for your home purchase, then you likely wont qualify for an exemption. Even if you do, your withdrawal will still be taxed as income.
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Navigating New Mortgage Technology
If youre buying a home in retirement, odds are mortgage technology has changed since your last purchase.
Even though age isnt a factor in getting a mortgage, seniors may face other hurdles in getting a mortgage when theyre retired. Hill said that some seniors may feel overwhelmed by the application process due to the paperwork required and a lack of familiarity with the technology involved.
Now that most mortgage applications are online and very rarely are there opportunities to meet face to face, they are often on their own, Hill said. It is a challenge trying to navigate the new technology, so finding a patient and knowledgeable Realtor is very important for seniors.
Hill suggested that older homebuyers work with a real estate agent who specializes in working with their age group. She also recommended bringing younger family members into the process, including attending meetings with their real estate agents and lender. Trusted relatives can make sure they fully understand the process and the contracts before signing, and can also help out with any technology challenges, Hill said.
Question : What Is Your Current Vested Balance
Your vested balance does not equal your total balance. Instead, this term refers to how much of your employer-sponsored plan would go with you if you were to leave your job or withdraw your 401 right now. While every dollar you contribute to your 401 is your money, the company-matching funds in your account are not immediately all yours. Every year, a certain amount of the matching funds is vested. Once youre fully vested, you can then claim the entirety of the employer match.
Note:Every employer is different with regard to the vesting period, and you will want to speak with your plan administrator if you have been with the company for fewer than six years . The IRS has a helpful entry on this topic.
Below is a snapshot of what Mark and Katies retirement plans look like:
Katie has been with her company just over two years and is only 20% vested. She also had a 401 at a previous employer rolled over into an IRA.
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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.
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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Benefits Of Borrowing From Your 401k To Buy A Home
The great thing about 401k loans is that they dont count towards your debt-to-income ratio. Using a 401k loan to finance your down payment can put you in a more favorable position for financing your mortgage. And, these loans are not reported to the credit bureaus, so they dont impact your credit score. It can also be beneficial to borrow from your 401k as a first time home buyer in order to make a higher down payment, especially in a competitive housing market. That said, you should consider the monthly payments on your 401k loan along with your monthly mortgage payment to ensure that these payments are within your budget.
If I Dont Use My 401 To Buy A House When Can I Use My 401
Put simply, 401s are meant to be retirement accounts, meaning that the money is ideally supposed to be used when you reach retirement age. The early withdrawal taxes that 401s and IRAs use are supposed to incentivize you to leave the money untouched until you reach retirement age.
However, hardship withdrawals do exist to allow you to borrow money early under extenuating circumstances.
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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.
Your Guide To Buying A Home In Retirement
People can buy a home at any time during retirement. There are no upper age limits on who can buy a home, or how many homes you can own.
Whether youre looking to downsize or relocate from a home you currently own, or youve decided to become a homeowner for the first time, buying a home in retirement offers many advantages. Chief among them is the ability to stabilize your housing payments with a fixed-rate mortgage rather than worrying about rent hikes each year.
A home is also a substantial asset that you can pass on to your children or grandchildren.
In this guide, youll learn different options for buying a home in retirement and how to determine which path is best for you.
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Getting A 401 Loan For A Home
If you’d like to use your 401 to cover your down payment or closing costs, there are two ways to do it: a 401 loan or a withdrawal. It’s important to understand the distinction between the two and the financial implications of each option.
When you take a loan from your 401, it must be repaid with interest. Granted, you’re repaying the loan back to yourself and the interest rate may be low, but it’s not free money. Something else to note about 401 loans is that not all plans permit them. If your plan does, be aware of how much you can borrow. The IRS limits 401 loans to either the greater of $10,000 or 50% of your vested account balance, or $50,000, whichever is less. For example, if your account balance is $50,000, the maximum amount you’d be able to borrow is $25,000, assuming you’re fully vested.
In terms of repayment, a 401 loan must be repaid within five years. Your payments must be made at least quarterly and include both principal and interest. One important caveat to note: loan payments are not treated as contributions to your plan. In fact, your employer may opt to temporarily suspend any new contributions to the plan until the loan has been repaid. That’s significant because 401 contributions lower your taxable income. If you’re not making any new contributions during your loan repayment period, that could push your tax liability higher in the interim.
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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Pay For Properties In Cash Inside The Plan
Paying for a property in cash inside your self-directed plan is a reasonably straightforward process. If you have confidence in real estate and its ability to earn you stable returns and appreciation over time, it is a great option. I utilized this strategy several times to make sizable profits over the years. If you dont have a large number of funds in your plan, you will want to find partners or get a loan as described above.
If Im Considering A 401 Loan What Information Should I Get From My Plan Provider
If youre considering taking a loan from your 401, ask your plan administrator for the following information:
- Whether or not loans are/are not permitted
- The minimum dollar amount required to obtain a loan
- The maximum number of loans permitted by the plan
- The maximum dollar amount permitted
- The term of repayment
- Any interest rate information
- Any required security for the loan
- How repayment may be made
- Any spousal consent requirements
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Retirement Account Withdrawal Comparison
So which is best? This depends on what accounts you have and how much you have contributed to them. But in general, youll be assessed fewer taxes and penalties if you withdraw money for your down payment from a Roth before a traditional IRA, and from either of those before a 401k. Whether a 401k loan is better than an IRA withdrawal depends on how large it is and whether it will affect your ability to qualify for the amount and type of mortgage you want.
- Contributions in Your Roth IRA: No income tax due, will not owe 10% penalty.
- Earnings in Your Roth IRA up to $10,000 for the Purchase of a First Home: No income tax due, will not owe 10% penalty.
- Small 401k Loan: Will not owe income tax or penalty. Monthly payments will be small and will have a minimal affect on mortgage qualification.
- Any Withdrawal From a Traditional IRA, SEP-IRA, or SIMPLE IRA up to $10,000 for the Purchase of a First Home: Income tax due, will not owe 10% penalty
- Earnings in Your Roth IRA Over $10,000 for the Purchase of a First Home: Income tax due, will owe 10% penalty.
- Any Withdrawal From a Traditional IRA, SEP-IRA, or SIMPLE IRA Over $10,000: Income tax due, will owe 10% penalty
- Large 401k Loan : Will not owe income tax or penalty. Monthly payments can be large and substantially affect mortgage qualification.
- 401k Withdrawal of Any Amount: Will owe income tax and 10% penalty.
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.
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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.