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Find out why it’s not a good idea to use your 401(k) to buy a house due to potential early withdrawal penalties and expensive taxes.
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Yes, pulling money out of your 401(k) to purchase a home is possible, but we don’t recommend it. Removing funds from your 401(k) before you hit retirement age – whether it’s for a new house or to buy one of your favorite 90’s toys now worth thousands – could lead to costly taxes and penalties for early withdrawals.
This guide will examine how you can access money in your 401(k) if you choose to go ahead with it, as well as the pros and cons of doing so and many alternative solutions for funding your dream home purchase.
Before using your 401(k) to buy a house, note that it's one of the best tools for wealth building. To encourage people to save for retirement, the IRS incorporated tax incentives with 401(k)s. Paycheck contributions toward your traditional 401(k) are pretax, which lessens your taxable income.
Tapping into these retirement savings early will have consequences. Accessing your 401(k) savings before the age of 59½ can incur a 10% early withdrawal penalty on the amount you’ve taken out. The money you withdraw will also be immediately subject to income tax because it’s no longer being stored in your tax-deferred 401(k).
However, the IRS does allow you to borrow up to 50% of your 401(k) account balance or $50,000, whichever is less. It's like a tax-friendly boost that helps you avoid the usual 10% early withdrawal penalty. To avoid paying taxes on the amount you borrow, you will have to pay it back, with interest, to your account.
There is one potential exception to the limit on the amount you can borrow from your 401(k): If 50% of your vested account balance equals less than $10,000, then you are allowed to borrow up to $10,000. But not all 401(k) plans are required to include this exception.
While it may sound like “free money,” in a sense, early withdrawals from your 401(k) can impact not only your current financial situation but also your ability to achieve your long-term retirement savings goals.
There are two methods of accessing the funds in your 401(k) to help you on your path to homeownership. Applying for a 401(k) loan is generally viewed as the better option than taking an early withdrawal from your 401(k), because it faces fewer taxes and penalties. Let’s examine both scenarios.
A 401(k) loan allows you to borrow a portion of your current 401(k) balance with no early withdrawal penalty. There is typically a cap on the amount you can take out as a loan of $50,000. The specific maximum dollar amount may vary by plan.
Interest rates on these loans are the Prime Rate plus 1% to 2%. The application process is straightforward, and the best part is that the interest you pay on the loan goes directly back into your 401(k). Another perk is that the money you take out with this loan will not be subject to income tax.
A few other key points:
The IRS allows you to withdraw up to $10,000 from your 401(k) for a first-time home purchase, but that total amount will face the 10% early withdrawal penalty and be taxed as additional income. Note that if you opt to withdraw that same amount from an IRA to buy your first home, the IRS will exempt you from the 10% penalty.
There is the possibility of getting your early withdrawal classified as a “hardship distribution,” but that can be challenging to achieve. The IRS requires that to qualify as a hardship, the funds distribution must be due to “an immediate and heavy financial need” and be “limited to the amount necessary” to meet the financial need.
You may be surprised to learn that your employer is responsible for determining what counts as a hardship withdrawal. It will be up to them to decide if your home purchase qualifies. And even if you receive a hardship classification, the amount distributed will be taxed as income.
We want to empower you to make informed decisions about using your 401(k) to buy a house. It’s a significant financial investment, so weighing the pros and cons is an important step in the conversation.
If you're set on buying a home, using your 401(k) should be your last resort. Consider these alternatives before touching your 401(k) with the risk of compromising your long-term financial security.
Many state and local governments offer down payment assistance programs to help first-time homebuyers. By leveraging these programs, you may secure a substantial portion of your down payment, reducing the need for a 401(k) withdrawal and preserving your retirement savings.
We suggest you explore some federal mortgage programs designed to make homeownership more accessible, including Federal Housing Administration (FHA) loans and Veterans Affairs (VA) loans. Both of these programs often come with competitive interest rates and favorable terms.
FHA loans are particularly beneficial for those with limited down payment funds, offering a lower down payment requirement of only 3.5% of the purchase price. VA loans, on the other hand, provide exclusive benefits for veterans, active-duty service members, and eligible spouses and may require no down payment at all.
Individual Retirement Account (IRA) withdrawals for first-time home purchases offer distinct advantages. Direct Roth IRA contributions can be withdrawn in any amount and at any time without penalty, providing flexibility for your homebuying process. Be aware that this only applies to contributions. Early withdrawal of earnings is treated as taxable income with a 10% additional tax.
If you have a traditional IRA, you can withdraw up to $10,000 penalty-free for a first-time home purchase. Any amount greater than that will incur a 10% penalty, and the amount would qualify as income for taxation purposes.
A home equity loan lets you borrow against the appraised value of your current property, thus leveraging the equity built up in your existing home. The interest rates are usually favorable, and you can typically borrow up to 80% of the equity in your home. The borrowed amount can then be used without restrictions, making it a viable solution for the down payment on a second home.
Gift funds from family or friends can significantly contribute toward your home purchase and allow your loved ones to actively participate in your homeownership dream. It's a positive and collaborative approach, but understand the potential tax implications and lender requirements that come with gift funds. Consult a financial advisor to make sure you don’t miss any details.
Prioritize your personal savings as a primary source for a down payment. This straightforward approach ensures that you're using funds specifically set aside for significant life goals, minimizing the need to dip into your 401(k). Although it may require time to accumulate the necessary funds, you can maintain financial flexibility and independence in your retirement years by tapping into your personal savings now.
Some homebuyers opt for more creative financing paths, like crowdfunding or peer-to-peer lending platforms, to rally support from a broader community without affecting their 401(k). By leveraging the collective power of small contributions, you can raise funds for your home purchase while preserving the integrity of your retirement savings.
Yep, you may not love to hear it, but old-fashioned patience is worth considering if you can’t purchase a house at this time. Instead of rushing into major financial decisions, consider establishing a dedicated savings fund for the purchase and monitoring the real estate market for favorable opportunities.
Patience allows you to build a strong financial foundation, enabling you to pounce when the right moment – or house – arrives. Doing so will simultaneously help you protect your retirement savings.
The best option to safeguard your 401(k) nest egg and continue its growth, is to avoid using your 401(k) to buy a house. By exploring some of the alternative strategies outlined above, you can potentially limit the tax consequences that can heavily impact your retirement savings. Playbook can help you choose the right solution.