Are you short of funds to buy your home? Down payment is the biggest entry barrier to buying a house. If you are having difficulty in accumulating funds for making a down payment, you may look at a 401(k)-retirement fund as a convenient cash sourcing option.
Can you use your 401(K) to buy a house?
Yes, technically, you can use your 401(k) to buy a house. While not all 401(k) plans allow it, you may have to check with your sponsor whether yours does. Before you make the decision, you need to know what you are getting into.
If you withdraw from a 401(k) before you turn 59½, or before you turn 55 and have lost or left your job:
- Your early withdrawals will incur a 10% early withdrawal penalty, and
- The withdrawn amount is subject to income tax.
These rules seem harsh, but they are exercised to prevent you from sidetracking your retirement goals. Remember your 401 (k) plan is designed to help you achieve a comfortable retirement.
How to use your 401(k) to buy a house?
If you have decided to go ahead with withdrawing from your 401(k) account, you have two options:
- Take a 401(k) loan: If your employer allows you to take a 401(k) loan, it should be your first choice because you can prevent getting penalized for making an early withdrawal, and the loan amount is not subject to income tax. It also does not affect your credit score therefore the interest you pay on this loan is not subject to your income nor creditworthiness.The maximum you can take as a 401(k) loan is $50,000. This amount must be repaid with interest (Normally prime plus 1 or 2 per cent). It is always best to talk with your 401 k administrators about their rules – not all plans are the same. Most allow for the continuation of contributions while also paying the loan down. But there are some that don’t and that is why it is important.
- Withdraw from your 401(k): If the first option is not possible, you are left with only the option of making a 401(k) withdrawal. You are likely to incur the early withdrawal penalty, and the withdrawal is taxed as income.
Should you use your 401(k) to buy a house? Cons
Although you can, there are some reasons for not using your 401(k) to buy a house. The biggest reason being losing out on the compounding interest your money could earn if you let it be in your retirement account.
For example, if you withdraw $10,000 from a $20,000 401(k) account, you are left with only $10,000 that will continue accruing interest over time. If the annualized rate of return is 7%, this $10,000 becomes $54,000 over a period of 25 years. If you hadn’t withdrawn $10,000, the amount could have been $108,000.
Other drawbacks of taking a 401(k) loan or withdrawing from your 401(k) include:
- You may have to pay penalties, higher interest, and fees for using money from your 401(k). This normally applies if you don’t pay the loan back as promised
- If you change jobs, it may get difficult to pay your 401(k) back in a lump sum.
The above reasons might make you rethink using 401(k) for buying a new home.
But, what are your alternatives?
If you decide that using your 401(k) isn’t the best option for you, there are other alternatives you can tap into. These include:
- IRA: IRAs are designed to allow special provisions for first-time homebuyers (withdraw up to $10,000, penalty-free but tax is still applicable). So, if you have an IRA, consider taking money from it rather than considering an early withdrawal from your 401(k). A Roth IRA is even a better option because it allows you to make a hardship withdrawal of up to $10,000, tax-free and penalty-free.
- FHA Loan: This government-backed loan has looser requirements to allow first-time homebuyers to purchase a property easily. This includes lower credit score requirements and low downpayment options.
- VA Loan: This loan is also government-backed available to those with a military connection. This includes low-interest rates, flexible terms, and no down payment feature.
Rick Pendykoski is the owner of Self Directed Retirement Plans LLC, a retirement planning company based in Goodyear, AZ. He has over three decades of experience working with investments and retirement planning, and over the last ten years has turned his focus to self-directed ira accounts and alternative investments. If you need help and guidance with traditional or alternative investments, call him today (866) 639-0066.