Buying a house is expensive. With real estate prices going up by the day, it’s getting harder to come up with funds to support the purchase of a new property. There are a lot of ways to save for a house fast, but one of the best ways to get the money you need is by using your 401(k).
If you are trying to buy a house and are looking into financing options, you might be exploring the idea of dipping into the money that’s in your 401(k) account.
You can use your 401(k) to purchase a house, whether by withdrawing or borrowing. However, it is not an advisable financial move, especially when considering there are other, better alternatives you can use.
Before you decide to dip into your 401(k) savings, make sure you have all the information necessary to make a sound decision that you will not regret in the long term. In this article, I will take you through the following:
- How you can use your 401(k) to buy a house.
- Whether or not you should do it.
- The reasoning behind it.
- What other alternatives you can look into when financing a new home.
Using Your 401(k) Account To Purchase a House
When you buy a house, there are a couple of extra fees that you need to pay before you can move in.
The down payment is the amount of money you pay upfront for a house, which is then subtracted from the rest of the sum. The closing costs usually include any additional fees for closing a transaction that the buyer might be subject to at the end of the process of buying a house.
If you need to use your 401(k) to buy a house, let’s take a look at what you should know about it.
Withdrawal From Your 401(k)
If you need the money quickly for a down payment, you might consider simply withdrawing money from your 401(k). If you decide to withdraw early from your retirement account, you need to keep in mind the limitations.
You Must Have a Hardship
First, the early withdrawal would have to be considered by the IRS as a “hardship withdrawal” to be approved by your employer.
A down payment for a house is a questionable hardship, but it is up to your employer to grant this request. You would have to talk to your supervisors to understand what conditions and standards they have for an early withdrawal from a 401(k) account to be considered a hardship.
Usually, if it is a down payment for your primary residence, it can be viewed as a hardship, and you will be able to make the withdrawal.
Once the withdrawal is approved, you may withdraw any sum of money that you need within the possibilities of your 401(k) account, as the money is yours to use. This is a withdrawal, so the amount does not have to be repaid.
However, you will have to pay a 10% penalty on the amount you will withdraw as an “early withdrawal penalty.”
There are exemptions to this rule, but this is how the withdrawal will play out in most cases. You should also consider that you will need to meet particular requirements to make this process happen.
You’ll Have Additional Taxes
In addition, you will have additional taxes on what you withdraw, as the money will no longer belong to a retirement account. The funds withdrawn from your 401(k) account counts as income, so in addition to the 10% penalty, you will pay income tax as well.
This might mean that another 20 to 30% of the amount you withdrew will be taken from your retirement account.
For this reason, withdrawing money from your 401(k) is usually considered a wrong financial move, and it is only recommended as a last resort. You can read what happens if you don’t save for retirement in your working years. You’re taking the money you saved for your retirement years, and this withdrawal would subject you to penalties and taxes that retirement accounts are usually exempt from.
Taking a Loan Out of Your 401(k)
Withdrawal is not the only way to use your 401(k) account to finance a new house. You also have the option of taking out a loan from the 401(k), which means borrowing money from your account. This financial move has its advantages and disadvantages, which I will delve into later.
Let’s see how this process works.
You’ll Pay Interest On Your Loan
Taking out a loan means temporarily borrowing money from your 401(k) retirement account and paying it back over a certain period at an interest. It is important to stress that not all 401(k) plans allow loans, so before you go further, you have to discuss the option of loans with your employer.
After ensuring that your employer will enable loans as part of its retirement plans, you can look into how borrowing from a 401(k) works.
You Can Only Borrow a Limited Amount
The amount you can borrow is limited.
You may borrow either a fixed sum of $50,000 or half of your 401(k) balance, whichever is less. The most you’ll likely be able to borrow is $50,000. If half your balance is less than $10,000, you might be allowed to borrow up to that amount anyway.
The loan will be paid back at an interest, which is usually the prime rate plus 1 to 2%.
You Have a Limited Time To Pay It Back
Finally, the amount borrowed needs to be paid back over a period you and your company agreed to. However, in most cases, this period will consist of five years. Having said this, given that this particular loan will be used to buy a house, you may be allowed to pay it back
over a longer time.
Now that I’ve covered how a 401(k) loan generally works, let’s go through its pros and cons, as this comparison can help you choose a solution that best suits your needs.
Pros Of a 401(k) Loan
One significant advantage of taking out a loan from your 401(k) account is that, unlike using a withdrawal, the money is not subject to penalties or taxation, no matter at what time you borrow.
Furthermore, with this type of loan, you will be paying your money back to yourself and not a third party. The sum you will inevitably pay back is going to your retirement account for you to enjoy once you retire.
Unlike other types of loans, taking out a loan from your 401(k) account is not considered in your debt-to-income ratio. The debt-to-income ratio is the percentage of the debt you have compared to your income. This ratio is important because it is taken into account for mortgage qualifying reasons.
A 401(k) will not be counted as a debt, so it will not hurt your chances of qualifying for a mortgage, which could contradict your property-buying intentions in the first place. If you are worried about buying a house with a Chapter 13 bankruptcy, don’t.
Another advantage that 401(k) loans have compared to other loans is that they are not reported to credit bureaus. Loans usually get reported, and they can harm your credit score, leading to financial consequences for you. However, your credit score will not be affected by a 401(k) loan.
Cons Of a 401(k) Loan
It is a policy for some companies not to allow contributions to your 410(k) account as long as you are in the process of paying back the loan you took out from that account. This is within your employer’s rights, and it means that your retirement fund cannot grow until you pay off the entire loan.
Another related disadvantage is that it can put you into a higher tax bracket. You may be wondering how this can happen when you’re still receiving the same salary from your employer.
Well, 401(k) contributions usually lower the amount of income that is taxable. Once you are not allowed to make contributions to your 410(k) because you borrowed money from it, the amount of your taxable income increases.
So, although your income won’t change, a bigger fraction of it will be taxed, which means that you will have to pay more taxes. Your monthly expenses then increase.
If you borrow money from the 401(k) account, you lose the chance of having that money accumulate interest every year. The money that sits in the retirement account multiplies by an interest rate, which means that the more time you leave this sum untouched, the more money will be available once the account becomes withdrawable.
By taking it out of the 401(k) account, you miss the chance of having a return on your investment. You’ll be subject to higher sequence of returns risk in your portfolio. Another critical question you should ask yourself before you agree to take out a loan is:
What would happen if you leave your job for any reason within the next few years?
If you leave your job and still haven’t paid off your 401(k) loan, you will be faced with consequences, the severity of which depends on your specific 401(k) plan. Some plans require the whole amount to be paid before you leave the job.
Other programs could give you up to 60 days to repay.
If you cannot do either, any unpaid amount of money will be taken from your retirement account, and it will be considered a withdrawal. This means that your account will take on the same penalties as a withdrawal, meaning that you will have to pay an early withdrawal penalty of 10% of the payment as well as pay income tax.
If you need financing for a house and you are looking into the possibility of using money from your 401(k) account, you are faced with two main options: a withdrawal or a loan.
Of the two, the loan is the better alternative, mainly because it is not subject to penalties and taxes, and it can be repaid, which means you put money back into the retirement account. Withdrawing, on the other hand, should be considered as a last resort move.
Why You Shouldn’t Withdraw From a 401(k) Account
Before moving on to other alternatives, you should thoroughly understand the purpose of a 401(k) account and how it works. This will help you recognize why withdrawing from this account to finance a house is not ideal.
A 401(k) is a retirement account, and as such, offers many added benefits, such as deducted taxes and a decent interest rate. When you don’t use the account for its intended purpose, not only will you lose its benefits, but you will also need to take on further penalties and tax increases.
A 401(k) is usually set up by companies for their employees.
Part of the salary is set aside every month and goes to this account. It is just money saved for you to use when you’re older and unable to work anymore.
Because it is a retirement account, you get a tax deduction for the money contributed to it. This means you get to enjoy a tax deduction while the amount saved in this account grows every year at an interest.
As a counterbalance for all these benefits, there are also some conditions and limitations set by the government on how you can use the money saved in this account. You cannot withdraw money from the 401(k) account until you turn 59 ½.
You can also withdraw money if you have turned 55 and you are no longer employed. If you withdraw earlier than the situations mentioned above, there are penalties.
This will happen because your money will no longer be considered in a protected account like a retirement version. You will get early withdrawal penalties on whatever amount of money you decide to withdraw, as well as income tax.
It might seem harsh on the government’s part to put all of these limitations on ways to use the money you earned, but this is done for good reason. The government tries to discourage using retirement money too early and not saving enough for a later time.
So, although it is possible to withdraw money from the 401(k) under certain conditions, it is not an ideal choice.
This type of financing will come with many strings attached, which can significantly harm your finances in the long run. Instead of withdrawing from your 401(k), consider taking out a loan or looking at one of the other options that I will be explaining in the following section.
Other Alternatives That Can Help You Purchase a House
Many other alternatives can help you finance a new home that doesn’t include using your 401(k) account at all. So, before deciding, take a look at these options that can help you buy your house without dipping into your retirement savings. This way, you keep your contributions in the retirement account safe from penalties and taxation, and you can use them by the time you retire.
Here are some alternatives that would keep your 401(k) intact.
Withdraw From Your IRA
Like 401(k), IRA is a retirement account, but it is not connected to your employer. You can withdraw up to $10,000 from your traditional IRA account without an early withdrawal penalty, but you will incur the income tax.
If you have a Roth IRA, this is an even better option to go for because that money has already been taxed, so you won’t have to pay any penalties or taxes. You still will be able to withdraw up to $10,000.
You’ll still have the balance of your portfolio available as well. So, if you are trying to retire on 500k for example, if you are only withdrawing $10,000, you still have $490,000 in there growing for you.
It is also possible that your Roth IRA account allows for hardship withdrawals, in which case you can withdraw any amount of money.
Use Down Payment Assistance Programs
You can check if you qualify for local or state assistance programs. These programs are created to help first-time or low-income house buyers. Some examples of these programs include grants, forgivable loans, low-interest loans, and many other alternatives you can look for in your state’s legislation.
There are a lot of benefits to these programs.
For example, sometimes, no payback is required at all. Other advantages include low/no interest or the option to start paying back many years after borrowing. You will need to ask your mortgage lender to see if you fulfill the criteria necessary to qualify.
Use Other First-Time Buyer Loans
There are other ways you can borrow money for your down payment without borrowing
from your 401(k).
For example:
- FHA loans: A government-backed alternative, which is ideal if you have issues with your credit score, requiring only a 580 credit score and a 3.5% down payment.
- VA loans: Another government-backed option, ideal for people with military connections, such as veterans and service members. Requires 0% downpayment.
- USDA loans: These are ideal for people who are buying property in rural areas. That said, you will need to check if you qualify first, as elected areas are qualifiable only. Requires 0% downpayment.
- HomeReady/Home Possible loans: These require a 3% downpayment and can offer additional options if you are a first-time homebuyer.
There might be other types of loans that might be available to you specifically, so you can check if there are any other state or local programs that can make it easier for you to buy a home. Whether you use a mortgage banker vs. a mortgage broker, both can assist you with options.
You should remember that loans, in general, will affect your debt-to-income ratio and, therefore, can also affect your credit score. So before deciding, take all possible alternatives and their respective long-term effect on your finances.
Additionally, some borrowers can get a mortgage loan from a foreign bank. This is a viable option if you have the necessary income and credit score.
Ask for Gifts/Help From Family
If there is someone in your family or circle of trusted people who can help with financing, you can consider asking them for money for your down payment. You can request multiple people to come up with the necessary amount, if possible.
There should be a paper trail documenting the amount of money gifted to you for your down payment. You will also need to ask your lender for more details.
Wait To Save More
While not ideal, this is often the best option for many young buyers.
So, if possible, consider postponing the purchase of a house until a more convenient time for you. Sometimes it’s better to wait a few more years, which will allow you to save more money in the meantime.
If you are confident that you will be able to generate adequate income and make saving a priority in your future, consider just waiting to buy a house at a moment when you have the necessary amount on hand, which means that you won’t need to borrow from your 401(k).
Can I Use My 401(k) to Purchase a Second Home?
Yes, you can use your 401(k) funds to purchase a second home. However, you may face certain penalties such as taxes and early withdrawal fees. If you are younger than 59 1/2 years old, you will be subject to a 10% early withdrawal fee plus income taxes on the amount withdrawn.
For example, let’s say you withdraw $50,000 from your 401(k) account to buy a second home. You will owe income taxes on the $50,000 at your ordinary tax rate. In addition, you will owe a 10% penalty of $5,000 because you are withdrawing the funds before age 59 1/2. So if you’re in the 25% tax bracket, you would owe approximately $20,000 in taxes and penalties (25% of $80,000).
Can I Use My 401(k) to Buy a Car?
Yes, you can use your 401(k) to buy a car. You can take a loan from your 401(k) and will have up to five years to pay it back. The interest you pay on the loan will go back into your account. However, some retirement plans limit the amount you can borrow over a set period of time. So if you’re considering this option, check with your plan administrator first.
You should also weigh the financing at the dealership vs interest rate offered from your plan. The dealership may offer you a lower interest rate, but remember that the loan will still come out of your 401(k) balance and will count towards a loan. You’ll be able to pay for a car in cash, but it’s important to note that you’re depleting your retirement funds.
If you don’t know if you will qualify for an auto loan, follow the steps how to get pre-approved for a car loan when you have bad credit to find out.
Conclusion
Although it is technically possible to use your 401(k) account to help pay for a house, it is not advisable. You may be better off saving the money in your retirement account to use for the future and exploring other types of loans and programs that can help you pay for the house.
If you decide to use your 401(k) for a down payment, keep in mind the options in this case and their respective pros and cons. In any case, you need to be informed in order to make the best possible decision for your financial future.
