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When it comes to your retirement funds, income after retirement most often comes to mind. But you can also use your 401(k) toward the down payment to buy a house before you retire.
In this post, we’ll look at using your 401(k) toward the down payment of your home’s purchase price and talk about common concerns, including: 401(k) withdrawal, early withdrawals and early withdrawal penalty
As well as Income taxes, taxable income, and whether you can claim interest payments as a tax deduction
Let’s dive into how you can use your 401(k) to buy a house.
Saving for a down payment
Saving for a home down payment can be challenging, especially considering the additional expenses associated with buying a house.
It’s no wonder so many homebuyers are thinking about 401(k) withdrawal to help with a home purchase.
Most homebuyers need to come up with a down payment, in addition to saving enough money to cover closing costs, moving expenses, and furniture for their new place.
Taking money from your retirement account can help you make a minimum down payment.
While there are drawbacks to using your 401(k) for a down payment to buy a house, it can be the right choice for many buyers.
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What is a 401(k)?
In simplest terms, a 401(k) is a retirement savings account offered through many companies. You can often set up automatic contributions to be taken from your paycheck.
Traditional 401(k) accounts are tax-deferred, meaning you don’t have to pay regular income tax on the money you put in this account right away.
Employees contribute a portion of eligible earnings to their traditional 401(k) retirement savings plan before paying income tax on it.
Employers can also make matching 401(k) contributions, which can translate into a more significant investment bump than a traditional IRA.
Your 401(k) withdrawal as down payment assistance
Depending on your employer plan, you can use your 401(k) to help buy a house.
In general, there are two ways you can use your 401(k) to make early withdrawals for a down payment: a 401(k) loan and a financial hardship withdrawal.
As a first-time homebuyer, it’s possible for you to take out a 401(k) loan.
Your employer typically sets up the specifics surrounding the loan.
You’ll be expected to repay the loan with interest within the repayment period, which is usually five years.
Loan rules can vary depending on your plan, but most allow you to borrow up to $50,000 or half of your vested account balance—whichever is less.
The vested account balance is the total amount of money you’re eligible to keep if you leave your current employer. The money you’ve personally contributed is automatically added to your vested account balance. Your employer’s contributions are added once you’ve stayed with the company for a designated amount of time.
A 401(k) loan is both tax-free and exempt from the 10% early withdrawal penalty. However, if you default on the loan, you will be responsible for paying back both the income taxes and the withdrawal penalty.
Financial hardship withdrawal
The IRS can allow a hardship withdrawal from your 401(k) to buy a primary residence or principal residence if you have an “immediate and heavy financial need.”
You will need to check, however, if your employer offers hardship withdrawals with your plan. They’re not required to offer either loans or hardship withdrawals.
Unlike the loan, you don’t have to pay this money back to your account, but the withdrawal amount is taxable.
Money from a 401(k) withdrawal for hardship reasons can’t be used to cover monthly mortgage payments, mortgage insurance payments (including private mortgage insurance), property taxes, or paying your real estate agent fee.
But you can use it toward your down payment for the purchase of a primary residence.
Getting approved for a hardship early withdrawal of money in your 401(k) retirement account isn’t easy. The IRS has stringent rules defining who is eligible to withdraw money.
It’s recommended that this option be treated as a last resort.
401(k) loans for down payments: The pros & cons
Some financial advisers recommend that you never touch your retirement account early. Others understand that it’s a viable option for one-time lump sum costs, without the high interest that can come with a personal loan.
Let’s look at the pros and cons of using a 401(k) loan toward a down payment to buy a house.
The pros of using your 401(k) loan toward a home purchase include convenience and ease.
Because a 401(k) loan doesn’t require a credit check, reaching out to credit bureaus, or evaluating your debt to income ratio, many borrowers find using their 401(k) to fund their down payment to be a faster and more convenient route to homeownership.
Other down payment assistance programs, like the FHA loan program—a government-backed loan program that helps homeowners with their down payment—require borrowers to meet minimum credit requirements.
It’s often a low, often no-cost option, thanks to the fact that you’re paying interest back to yourself.
The cons of using a 401(k) for a home purchase down payment include losing out on the investment returns your money would have earned if it stayed in your 401(k).
The IRS doesn’t consider the interest on your payments to be new contributions or additional contributions—therefore, they aren’t tax-deductible.
If you decide to leave your employer before repaying your 401(k) loan, things can get messy. You’ll need to repay the outstanding balance by the tax filing deadline for that year. Failing to do so can mean defaulting on your 401(k).
While defaulting on your loan won’t destroy your credit or put you into collections, it’s far from ideal. More importantly, it can significantly reduce your retirement savings.
Alternatives to using your 401(k) to buy a house
Many first-time homebuyers think they have to come up with enough money or take money out of their 401(k) to cover down payments. But the reality is —that’s not always necessary.
Saving for a down payment doesn’t have to be complicated.
In addition to traditional home loans, first-time homebuyers have a few alternatives to using their 401(k) to buy a house such as using their personal savings.
Some loan programs also allow gift money—money from friends or family members—to be used for a down payment.
Is a 401(k) loan right for me?
Deciding to withdraw from a 401(k) will mean taking a good look at your financial situation.
Begin by contacting your plan administrator.
It’s also a good idea to speak with your financial advisor for income tax guidance or information about taking money out of your 401(k).
Take a look at other down payment assistance programs, including federal government-backed mortgages like FHA loans, to see if you qualify.
Have questions about buying a home? Homefinity can help
If you have questions about buying a house, including: 401(k) mortgage loans, closing costs, down payment, or preapproval, reach out to a Homefinity home loan officer.
Homefinity has the resources and experience to help people make their dream of home ownership come true.
Fill out our brief online application to set up an appointment that is convenient for you and we’ll talk through some possibilities.
The information in this article does not constitute financial planning advice. Please consult a financial planner regarding your specific situation. This article does not constitute tax advice. Please consult a tax advisor regarding your specific situation. Eligibility to programs mentioned are subject to program stipulations, qualifying factors, applicable income and debt-to-income (DTI) restrictions, and property limits. Fairway is not affiliated with any government agencies. These materials are not from HUD or FHA and were not approved by HUD or a government agency. Some references sourced within this article have not been prepared by Fairway and are distributed for educational purposes only. The information is not guaranteed to be accurate and may not entirely represent the opinions of Fairway.