May 27, 2020
6 MINUTE READ
Thinking about using your 401(k) as a down payment for a house? Buying a home can be a huge step toward securing your own financial future. And, especially if you live in a bigger city, it can often be more affordable to buy a home than to rent one — assuming you have a big enough down payment for a house, of course.
Traditionally, a 20 percent down payment has been encouraged. On top of this down payment, you will also be responsible for covering closing costs, which include all applicable attorney fees, a year’s worth of homeowners insurance, and at least a few months of property taxes. When you add it all up, it quickly becomes a serious savings goal — and sometimes even seems unattainable.
One option for quickly boosting your down payment is to tap into your existing 401(k). And before any financial experts stop us to say what a terrible idea this is, we’re here to agree that, at least in most cases, it can be. The funds in your 401(k) have already been allocated for a specific purpose — namely, your retirement savings. And, what’s more, there can be some pretty serious consequences for accessing this money early.
Of course, there are always two sides to every story… and there actually are some instances where it can make sense to tap into your 401(k) funds for a down payment on a house. And, let’s be real, some people are going to pull funds out of their 401(k) if they want to, whether or not it’s the best idea.
401(k) accounts are accounts that are specifically set up for retirement savings, which is why these accounts get certain tax breaks. In exchange for receiving a deduction on the money contributed to your 401(k) and letting the funds grow tax-free, the government restricts and limits your access to the funds in your account.
You aren’t supposed to withdraw funds from your account until you are 59-and-a-half, or 55 if you have left your job or lost your job. If you don’t meet these requirements and you still decide to withdraw funds, you will incur a penalty on the funds withdrawn and be responsible for paying income tax on anything you withdraw (more on this later).
Still, the money is your account is, after all, yours — and you have the right to it. If you’re thinking of accessing your 401(k) to help fund your home purchase, here are # things you should know.
If your plan allows, you can withdraw the funds in your 401(k) through what is known as a hardship distribution. Keep in mind that these types of withdrawals aren’t required by law, so many plans don’t even allow them. However, if yours does, it can be an option to liquidate your account. You’ll 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(k) is to borrow the money (again, assuming your plan allows for this). Certain conditions must be met in this case, however. For example, the loan has to carry a reasonable interest rate. Also, the loan can’t exceed 50% or $50,000 of the account’s vested value, whichever is less. If you have less than $10,000 in your account though, you may borrow the account in its entirety.
If you withdraw money from your 401(k), it is immediately classified as taxable interest, and you will have to pay income tax on the money as if it was additional income. And, if you are 59-and-a-half or younger, the IRS will add an additional 10 percent penalty for withdrawing the funds early. Borrowing from your 401(k) will let you dodge the additional taxes and penalties, but this strategy isn’t entirely without risk, either.
As with any other loan, you’ll have to make loan payments on the money you borrow from your 401(k), including interest — which could then affect your ability to get a mortgage. And, even though the interest gets paid into your 401(k), the lower balance will earn less money, leading to a potential gap in your retirement savings. What’s more, you are paying your loan with “after-tax” dollars — meaning that you’ll end up paying taxes twice on the same money (once when you earned it, and again when you take it out of your 401(k) later).
As mentioned, even though it is possible, it can be problematic to use your 401(k) to buy a house. Essentially, you are diminishing your retirement savings — both in an immediate drop in balance but also in its potential for future growth.
Let’s look at this another way. Let’s say you have $40,000 in your 401(k) and you take out $20,000 to use for a down payment, leaving $20,000 in your account. That $20,000 has the potential to grow to $108,000 over 25 years, assuming an annualized return of 7%. But the original $40,000 could have grown to $216,000, assuming the same rate of return.
If you decide that you have to tap into your retirement savings to help pay for a house, you’d be better off taking a look at some of our other accounts first, particularly any IRAs that you may have — and especially if you are buying a home for the first time.
Unlike your 401(k), an IRA (Individual Retirement Account) has special provisions built in to help first time home buyers or people who haven’t owned a primary residence within the past two years, per the Internal Revenue Service.
If you have one, try taking a distribution from your Roth IRA. You are allowed to withdraw your Roth IRA contributions if your particular plan allows for distributions from your account due to a hardship. And if the money is used to make a first-time home purchase, you are allowed to withdraw as much as $10,000 tax-free.
If you don’t have a Roth IRA, there are also options for a first time home purchase with a traditional IRA. As a first time home buyer, you can take up to a $10,000 distribution from your IRA without facing the 10 percent penalty — although the distribution will still count as income when it comes time to do your taxes.
Funds from a retirement account are best used to satisfy an immediate cash need, such as good faith or earnest money for an escrow account, a down payment, closing costs, or something similar. And keep in mind that borrowing from your retirement plan can negatively affect your ability to qualify for a mortgage loan. Even though you technically owe the money to yourself, it still counts as debt — and will show up as such on your credit report.