Retirement Funds Don’t Have To Be Off
Thomas J Catalano is a CFP and Registered Investment Adviser with the state of South Carolina, where he launched his own financial advisory firm in 2018. Thomas’ experience gives him expertise in a variety of areas including investments, retirement, insurance, and financial planning.
For those who invest in their 401 plan, the traditional thinking is to wait until retirement before taking distributions or withdrawals from the account. If you take funds out too early, or before the age of 59½, the Internal Revenue Service could charge you with a 10% early withdrawal penalty plus income taxes.
However, life events can happen, which might put you in a position where you need to tap into your retirement funds earlier than expected. The good news is that there are a few ways to withdraw from your 401 early without incurring a penalty from the IRS.
What Is An Ira
An IRA is a type of account set up at a bank, brokerage firm, mutual fund company, insurance company or other types of financial institution. Regardless of where the account is held, the purpose is the same: it is a place to hold assets to be used during retirement. IRAs can be used to invest in many types of assets . Some IRAs can be self-directed, allowing you to choose how to invest, ranging from investing in CDs, government bonds, mutual funds, stocks, even investment property .
There are many kinds of IRAs, but the two most common are Traditional IRAs and Roth IRAs. They differ based on the tax rules that regulate each type of IRA account, and specifically, how and when the account holder gets a tax break.
What Are The Cons
Besides the fees, your employer will likely stop their side of the match, if they were making one. Even when youre paying yourself back, your employer wont consider those funds a new contribution and therefore wont match it. It also might make it more difficult to qualify for a mortgage, as it can affect your debt-to-income ratio you should still be sure to shop around to find a lender that can offer you the best program that fits your financial needs. And of course, youll lose out on the compound interest your money would have been earning if youd left it in the account.
Of course, if you decide to withdraw rather than borrow from your 401, the main con is the giant tax hit youll suffer.
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Take Out A Personal Loan
Typically, acceptance for personal loans is based on your income and . While every lender is different, in some circumstances, it’s possible to take out up to $100,000 to put toward a down payment.
However, it’s important to be aware that taking out a new loan can raise your debt-to-income ratio, which can hurt your ability to be approved for a mortgage. You’ll want to check with your lender to verify you’re able to take on more debt before taking out any new loans.
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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The Basics On Using 401k To Buy A Home
A 401k loan is a preferred method if you think about using 401k to buy a house. Thats because theres a much lower cost associated with using 401k for down payment loan compared to withdrawing from 401k. If you decide to borrow the money, youll be asked to repay the loan within five years with interest, which is generally at the interest rate of 2 points over a prime rate. Nevertheless, the interest will be practically used to pay yourself, which makes it far less tedious. Only keep in mind that loans are paid with after-tax dollars! What does it mean? If you consider taking money out of 401k for house, you will be missing out on the tax benefits that make 401k accounts attractive in the first place.
In addition to that, if you use a 401k for a down payment right before you leave your job, the total amount must be repaid before you file taxes for the year in which you decided to quit your job. If you dont honor the given deadline, its operation will be considered a withdrawal, and the amount now withdrawn- will be taxed at ordinary income tax rates.
There are other pros to a 401k loan:
- It doesnt count toward the debt-to-income ratio, and credit bureaus wont take it into consideration against you.
- Taking a 401k loan wont hurt the credit score or affect the odds of qualifying for a mortgage.
The maximum amount allowed to be withdrawn in a 401k loan is 50,000$ and here are some further stipulations:
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.
Further, 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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Tap Your Ira Or Roth Ira Instead
Best for: First-time homebuyers who need $10,000 or less for a down payment
You normally need to be 59½ to take penalty-free distributions from your IRA, but the IRS allows an exception for qualified first-time homebuyer distributions.
As long as you put any early distributions of up to $10,000 toward buying or building your first home, you wont have to pay the additional 10% tax on it.
Can You Use Your 401 To Buy A House
Retirement accounts are just that: money thats being set aside for you to use in your golden years. And if youve been carefully saving, you might be wondering if its OK to tap those funds to use for something right now, like a home purchase, given that its an investment in its own right.
One of the most common types of retirement plans is the 401, which is often offered by companies to their workers. It provides an easy way to earmark some of your salary for retirement savings, along with the tax benefits that a 401 brings. Youll be setting aside money without paying taxes right now and then will pay the taxes when you withdraw it, which ideally will be when youre in a lower tax bracket than youre in now. In many cases, companies also match up to part of your personal savings, which is another reason that 401 accounts are so popular, since thats essentially free money.
But those funds have been set aside specifically for your retirement savings, which means that if your plan allows you to withdraw it earlier, youll pay a penalty, along with the taxes you owe given your current tax bracket. Theres usually the potential to borrow from it, though, which may be a better option.
So, while you can use your 401 for a first-time home purchase in most cases, the question is whether you should.
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Who Gets The Interest Payments From A 401 Loan
You get the interest you pay on the 401 loans, since you are essentially lending money to yourself. Keep in mind that the interest payments are made with after-tax dollars. That’s a downside to 401 loans, because those after-tax dollars will be taxed again when they’re taken out as a 401 withdrawal in retirement.
How To Use Your 401 For A Down Payment
While its possible to fund a down payment from a 401, its generally not recommended. Still, if you want to proceed, there are two main ways:
These are the key differences between 401 loans and withdrawals:
|Amount limited to the lesser of 50% of your vested account balance up to $50,000||Cant exceed the amount needed to purchase your home|
|Might become due in full if you lose or leave your job||Not affected by losing or leaving your job|
|Not taxable unless you fail to repay it||Income tax is due on the amount withdrawn|
|No tax penalty unless it isnt repaid||Might incur a 10% early withdrawal tax penalty|
|Might not be able to make new contributions during loan repayment||New contributions can be made after|
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Can You Use A 401 To Buy A House
Before you quickly search up 401k first time home buyer, heres the answer: If youre a first-time home buyer, and your employer plan allows it, you can use your 401 to help buy a house. There are a couple of ways to access the funds.
First, its possible for a first-time homebuyer to take a loan from an existing 401. Your employer generally sets the rules for 401 loans, but you typically must pay back the loan, with interest, within five years. You pay yourself interest to help offset the loss of investment growth, since the funds are no longer invested in the market.
You can take out a 401 loan for a few different reasons , depending on your plans policies. Those using a loan to purchase a residence may have more time to pay back the loan.
In certain rare circumstances, in the case of an immediate and heavy financial need, the IRS will allow you to make a 401 hardship withdrawal to purchase a primary residence. Hardship withdrawals do not cover mortgage payments, but using a 401 for a down payment for a first-time home buyer could be allowed.
The IRS has very strict rules for qualifying for a hardship withdrawal . And if you dont meet them, the funds you withdraw will be subject to income tax and a 10% early withdrawal penalty.
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.
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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.
Considering Life After Retirement
Lastly, you need to consider the loss of retirement income, since that’s what a 401k is supposed to be. During the recession, a lot of people saw their accounts shrink down to nothing. Many of these people later kicked themselves for not withdrawing the money. This adds another variable into the mix — the safety and security factor. You can see why it’s not a question I can answer for you. There are just too many “it depends” scenarios to think about. But hopefully, after reading this article, you’ll know exactly what to research and consider.
Here’s some recommended reading I want to leave you with. There’s an article on Bankrate.com called “10 Ways to Come Up With a Down Payment.” It’s worth reading. It provides a short overview of different strategies you can use, along with the pros and cons of each.
This article deals with the question: Can I use my 401k to buy a house in 2010? If you have additional questions about the home buying process, mortgage loans, or related topics, you can do a search at the top of this page.
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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.
Buying A Home Is A Big Financial Investment And Even If You Dont Have The Cash To Purchase A Home Outright Youll Probably Still Need Money On Hand For A Down Payment
If you havent saved for a down payment, though, you might be considering other ways to get access to the money you need now, including your 401. Thats because some 401 plans let you borrow money from your retirement savings and pay it back over time.
But even if you arent planning to retire any time soon, taking a loan from your 401 can come with big drawbacks, like missing out on potential investment growth. So before you dip into your nest egg, consider if its really the best option for you.
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What Are The Borrowing Limits For A 401
In general, you can only borrow up to 50% of your vested account balance or $50,000, whichever is less. Some plans may offer an exception if your balance is less than $10,000 you may be allowed to withdraw the entire amount. With a withdrawal, there are no limits on the amount, assuming your plan allows you to do so.
What Is The Difference Between An Ira And 401k
As outlined above, the key differences between an IRA and 401k are as follows:
- Anyone who falls within the income criteria can set up an IRA, whereas a 401k must be established by an employer.
- There are no income limits for investing in a 401k.
- Individuals can only invest up to $6,000 in an IRA each year vs. up to $19,000 in a 401k.
- Money can be withdrawn from an IRA at any time, whereas a person must have reached a distribution event before they can access their 401k savings.
- Investment selection may be more limited when investing in a 401k vs. an IRA.
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