For most people, purchasing a home will be the most expensive purchase of their lives; even the down payment is the most money they've ever had to come up with. If you are fortunate enough to have a substantial 401(k) retirement plan, you may be wondering if you can use the funds in it to purchase a home.
Yes, you can, in a nutshell.
After all, the money in your 401(k) is yours to spend however you see fit. However, your 401(k) should not be your first port of call for cash. If you withdraw money from your 401(k) (that is, before age 59½), you will almost always have to pay a penalty plus income tax. Even if you avoid these financial snares, you'll miss out on years of tax-free, compounded growth in your retirement nest egg.
Nonetheless, it may make sense in some cases to use your 401(k) to purchase a home. You have two options for doing so: borrowing or withdrawing. Both approaches will be explained in this blog!
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Using 401(k) funds to purchase a home:
401(k) accounts are designed to provide you with an income in retirement, and there are rules in place to encourage you to keep the money in the account until you reach the age of 59½. Normally, if you withdraw funds from your 401(k) before this age, you must pay a 10% penalty as well as income tax. As a result, withdrawal is an expensive option.
This rule is subject to two types of exceptions:
1) The first is if you have a Roth 401(k) plan. Because you've already paid taxes on your contributions, there are no early withdrawal penalties if you withdraw the money you've paid in. However, there are penalties and taxes if you withdraw money earned through interest or appreciation, so you should exercise caution when doing so.
2) The other exemptions from the standard 401(k) withdrawal rules are based on your personal circ*mstances. If you have significant medical expenses or are facing foreclosure, you may be eligible for one of these exemptions. Importantly, you can also get an exemption for a home down payment or closing costs.
Making a down payment with your 401(k):
You may have heard that you can withdraw funds from your 401(k) without penalty for a down payment on your first home, but this is not entirely correct.
The misunderstanding stems from the IRS's 401(k) withdrawal rules, which state that "costs relating to the purchase of a principal residence" are a type of "hardship withdrawal," and this type of withdrawal is usually exempt from the 10% penalty imposed on an early distribution. This could imply that if you're a first-time homeowner, you can withdraw funds — in this case, up to $10,000 — from your 401(k) without incurring any penalties.
However, while the IRS classifies principal-residence costs as a hardship withdrawal, they are not exempt from the 10% additional tax when taken from a 401(k). (When taken from an IRA, it is — more on that later.)
In other words, you can withdraw the funds, but you'll almost certainly have to pay a penalty. However, you should check with your employer and the 401(k) rules they've established. To be considered a hardship, the Plan must permit it. Also, it must be necessary, which implies that there is no other option - that is, you do not have any other assets that could cover the costs. Even if the penalty is waived, the funds will be subject to income tax, so multiply the withdrawal by your combined federal, state, and local marginal rates to determine the actual available funds.
Using 401(k) funds to purchase a home:
The second way to use your 401(k) funds to buy a house is to take out a loan from your plan. You do not have to pay the early withdrawal penalty or income tax on the amount you initially withdraw because you are essentially lending money to yourself. You will not owe the IRS any additional money for this type of withdrawal if you pay it back on time.
You can take $10,000 or half of your plan vested amount (whichever is greater), up to a maximum of $50,000. This type of loan is provided by your 401(k) plan provider — double check that they allow it — and the interest rates and loan term are set by them. You should also keep in mind that, unlike your initial contributions, you will be taxed on your repayments.
Using your 401(k) to finance a home purchase is a viable option, but not without its drawbacks.
Advantages:
- It’s a sure thing: You won't have to go through a credit check or submit paperwork to a third-party lender for approval.
- It’s fast: The process of selling your assets and receiving the proceeds takes only a few days at most.
- It offers good terms: Typical interest rates for 401(k) loans are 2% above the prime rate. In addition, since you are repaying yourself, your financial situation will be the same once the loan is paid off as it was before (apart from missing out on interest the account investments would have earned otherwise).
Disadvantages:
- It's likely that you'll be hit with a 10% penalty if you cash out now. High-rate taxpayers should be aware that they will additionally have to pay income tax on the withdrawn amount. The sum you ultimately receive will be reduced due to both of these factors.
- Both taking out a loan against your 401(k) and taking money out of it might be costly in the long run due to the lost opportunity cost of compound interest on your retirement savings. With a 7% annual growth rate, your 401(k) will be valued $54,274 less in 25 years if you withdraw $10,000 now.
- The value of your account can be significantly impacted by any action taken, including taking out a loan, not only because of the interest you lose but also because you can't make any additional contributions to the plan during the loan's term.
Ways to Buy a House Without Using Your 401(k)
As a rule, these alternatives are preferable to tapping into your 401(k) to finance a home purchase.
- Wait to make that buy. Putting off homeownership for a few years to save for a down payment and bolster your 401(k) contributions will almost certainly benefit your financial situation in the long run (or whenever retirement looms).
- Tap your IRA. Distinct from 401(k)s, there are no penalties for withdrawing up to $10,000 from a traditional IRA to put toward a home purchase. When it comes to a Roth IRA, contributions and, if you're over the age of 59½, earnings, are always available for withdrawal.
- Investigate no or low down payment financing options. You can reduce the amount of money you need for a down payment by applying for a mortgage through the Federal Housing Administration (FHA) or the U.S. Department of Veterans Affairs (VA). When compared to the standard 20% down payment required by commercial lenders, their loans have down payments of merely 10% or 3.5%. Fannie Mae and Freddie Mac, GSEs backed by the federal government, also back mortgages with modest down payments.
The final word on using a 401(k) to buy a home:
Withdrawing from a 401(k) plan is not a wise financial move. You will lose years of potential interest growth on the money you withdraw, and the penalty for withdrawals are purposefully high. You shouldn't count on your 401(k) as a backup plan if you need money for a down payment on a house.
However, there are specific scenarios where this might be the best course of action. You might want to borrow from your 401(k) if you're in a rush to buy a home but don't have access to an individual retirement account or government-backed mortgage program. Make sure you can afford to repay the loan fast so you can keep contributing to your 401(k) as usual.
Don't forget to check out!
How Can I Avoid Paying Taxes On My 401k Withdrawal?
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20 Answers to the Most Common Tax Questions
Should you tap into your 401k to buy a second home? Well, the most likely answer is no. So, the reason for this is that a house, whether it's your main home or a second home like a lake house or a vacation home, is not an investment.
People think of them as investments, but in reality they are not. If you look at all of the data from the past, you can see that home prices are not really a good investment. Also, most people don't sell their homes or second homes when they retire. Instead, they keep living in them or give them to their children. If you can pay for it, there's no reason not to do it. It's a great thing for your family to have. But if you have to take money out of your 401(k) and risk your future to do so, you might want to rethink your investments.
I hope this information was helpful. If you have any questions, feel free to reach out. I’d be happy to chat with you.
About the Author
As Managing Partner of Vincere Wealth, Josh assists clients in navigating financial challenges and making sound financial decisions. Having someone guide you in making sensible financial decisions today can have a substantial impact on your future financial wellbeing. Josh takes great pride in guiding customers through the complexities of taxes, real estate, businesses, employer stock, and international financial planning.
If you're interested in an investment advisory or financial planning relationship, please consider Vincere Wealth Management.
Schedule a FREE 1:1 session here to connect with a #VincereWealth Advisor.
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