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If you don’t have enough cash to pay down on your house and you participate in a retirement plan, you may be able to use it for this purpose. But should you take money out of your 401(k) to buy a house? It all depends on your options, credit score, and current finances. Borrowing your 401(k) account — or any other attractive loan — to buy a home is a risky move, and we’ll see why in a minute.
Keep in mind that any withdrawal you make today means that you would be jeopardizing retirement funds for the future. In addition, you would be losing a series of compound interest and profits from the investments made by the administrator of your plan.
Table of Content
- How does the 401k retirement plan work?
- 401(k) Loans: How does a 401k loan work?
- Withdrawals vs. Loans: Can I Withdraw My 401(k)?
- Disadvantages of Using Your 401(k) to Buy a Home
- Alternatives to make the most of your 401(k)
- In short, can I take my money out of my 401(k) to buy a house?
How does the 401k retirement plan work?
Before we get started, let’s do a quick review of the 401(k) account rules. 401(k) accounts are designed to save for retirement, which is why 401(k) account holders get certain tax benefits. Arguably, in exchange for giving you the opportunity to take a deduction on the money contributed to the plan and letting that money grow tax-free, the government severely limits access to the funds.
What are these limitations? To make a quick summary, you’re not supposed to withdraw your funds until you’re age 59 1/2 or, if you’ve lost your job, age 55 or older. If none of these cases apply to you and you withdraw the money, you will have to pay an early withdrawal penalty of 10% calculated based on the amount of money withdrawn.
To top it off, account holders who make early withdrawals will also have to pay taxes on the distributed amount , just as they would any other distribution from the account, regardless of their age.
Note: Regardless of limitations, the money in the 401(k) account is yours and as such, you are entitled to it. If you want to use the funds to buy a house, you have two options. First, borrow from your 401(k) account and second, withdraw the money early.
401(k) Loans: How Does a 401k Loan Work?
Of the two options above, taking out a 401(k) loan is the more desirable. Keep in mind that when you apply for a 401(k) loan, you do not incur a penalty for early withdrawals and you will not have to pay income taxes on the amount you withdraw. In this case, you will have to pay yourself, that is, return the money to your account and with interest.
That’s right: interest on 401(k) loans is subject to a prime rate of one or two percentage points. The 401(k) account provider or administrator typically sets the interest rate and other payment terms and conditions. However, at least in general, the most common is to grant a term of (maximum) five years to pay off the loan.
Note: Depending on the administrator of the funds, it is possible to extend this term of return of the money for a few more years as long as it is used to buy a main home.
Warning: Keep in mind that even if they are invested in your account, these refunds do not count as contributions. Therefore, there is no tax exemption in this case and, of course, no employer will match these refunds that you make. Your plan provider may not even allow you to make contributions to your 401(k) while you pay off the loan.
Now, how much money can you borrow from your 401(k)? Typically, an amount equal to one-half of your account’s vested balance or $50,000, whichever is less.
COVID-19 situation
As of the enactment of the CARES Act due to the pandemic, this maximum limit was raised to $100,000 for 2020. In addition, there are several payment conditions and tax flexibility that could benefit you.
Withdrawals vs. Loans: Can I Withdraw My 401(k)?
Essentially, you can make withdrawals from your 401(k) account, especially when the plan provider doesn’t allow borrowing. In this case – or if you need more than the $50,000 limit – then you could opt for a full withdrawal of the account balance.
Technically, you would be doing something known as a hardship withdrawal . However, proving that the withdrawal is due to financial need at the time of purchasing a new home may be difficult to do. However, and generally, the IRS allows withdrawals whenever the money is urgently needed, for example, to pay a down payment on a main home.
Note: You will likely incur a 10% penalty on the amount you withdraw unless you meet very strict rules to qualify for an exemption. Even then, you would still be required to pay income taxes on that amount withdrawn.
Important: By making a withdrawal, you will be able to access the amount you need to meet your financial needs. Also, remember that you are not obliged to return this money to your account. However, if you wish, you can replenish your 401(k) account balance by ordering an additional deduction from your paycheck.
Watch out! Borrowing money from your 401(k) account could affect your ability to qualify for a mortgage. Even if you owe the money to yourself, in the eyes of a bank, that debt is the same as any other debt you have in your history.
Disadvantages of using your 401(k) to buy a home
While it’s possible to use the money in your retirement account to buy a home, it’s a problematic decision no matter how you look at it. Think that, by doing so, your savings will decrease, but we are not only talking about the balance of the account, but also its future growth potential.
To see it more clearly, let’s take an example . Imagine that you have $20,000 in your account and you withdraw $10,000 to complete the down payment on your house. That $10,000 you have left could turn into $50,000 in 25 years with a moderate annualized return of 7%.
But what happens if you don’t withdraw money from your 401(k) and leave the $20,000 in the account? Well, in that case, the money would rise to $108,000 in the same number of years and under the same performance circumstances.
Alternatives to get the most out of your 401(k)
If you have no other option to put together a down payment on your house than to deplete your retirement savings, we recommend that you first go to your IRA accounts, especially if this is your first home. Unlike 401(k)s, IRAs have special provisions for first-time homebuyers, meaning those who haven’t owned a main home in the past two years according to the IRS.
But which IRA to withdraw from? The first option is to request a distribution from your Roth IRA, if you have one. Remember that you can always withdraw your Roth IRA contributions in tough times. You can also withdraw up to $10,000 of earnings tax-free if the money goes toward a first home purchase.
The next option would be to take a distribution from a traditional IRA. In this case, as a first-time homebuyer you can withdraw $10,000 without having to pay the 10% tax penalty, although this would not free you from paying federal and state income taxes.
Note: If the distribution is more than $10,000, a 10% penalty will be applied, but only to the additional withdrawal amount.
COVID-19 situation
On March 27, 2020, United States President Donald Trump signed the CARES Act, a $2 trillion economic relief bill. This norm allows distributing up to $100,000 without having to pay the 10% penalty to which the age group that has not reached the age of 59 and a half is subject to. Retirement account holders also have three years to pay the tax due on the withdrawals or even repay it to avoid paying taxes. Of course, this refund may exceed the annual contribution limit.
In short, can I take my money out of my 401(k) to buy a house?
Figuring out how to put the funds in your 401(k) account to good use should be your goal. Of course, you can access them if you need to cover an immediate need for cash ; such as placing them in escrow, using them for a down payment on a home, paying closing costs, or any other amount the lender requires, such as private mortgage insurance.
However, you should be aware that taking out a loan from your retirement plan could affect your ability to qualify for a home loan . At the end of the day, it weighs as much as a debt with the bank would, although in this case you are a lender and a borrower at the same time.
Now, if you need a distribution of your retirement savings, your first option should be to go to your Roth IRA or, if you don’t have one, a traditional IRA. If you don’t have any of these accounts — ultimately, that is — you might be able to access your 401(k) funds, but as a loan.
If your financial situation does not allow you to apply for a loan yourself, the last resort would be to agree to an early distribution. Then:
- You can use the funds in your 401(k) account to buy a home, either by borrowing the money or by withdrawing the money from the account. (The best option will always be the loan)
- Keep in mind that a 401(k) loan is not unlimited: it has a limit. In addition, you must repay the money -with interest- so that it does not generate an income tax debt or have to pay tax penalties.
- While making a withdrawal from your 401(k) account is more flexible—because there’s no cap on the amount—it’s generally limited to the amount of contributions you’ve made to the account. The only way this early withdrawal will not be subject to penalties is if it is classified as a hardship distribution. But, in this case, you would have to pay equal income tax on that withdrawn amount.
- Withdrawals from an IRA or Roth IRA are preferred over those from a 401(k). If you can, opt for this option first.