Can You Draw From a 401k for a House

401k Withdrawal Rules for Home Purchase 2021

CASAPLORERTrusted & Transparent

What You Should Know

• It is possible to withdraw money for a down payment from 401(k), but it is likely not the best solution.
• You can access the money in 401(k) with two methods: 401(k) Loan and 401(k) "Hardship" Withdrawal.
• Withdrawing from a 401(k) account before 59 and a half years old will have a 10% penalty fee and will be subject to income tax.
• Multiple options may be more appropriate for a home purchase. These options include personal savings, family help, IRA, and others.

The minimum down payment required for a loan is the largest obstacle to buying a home. Even if you know your income is more than enough to support your mortgage payments, you may not have enough saved for the large 20% down payment that some mortgages require. Many people look at their assets and think taking money out of their 401(k) is a quick and easy method of meeting this requirement. However, there are many conditions and drawbacks to consider before withdrawing from your 401(k).

What is a 401(k)?

A 401(k) is a company-sponsored retirement account. It is called your 401(k) because the foundation for this savings plan is the 401K provision in the IRS code. Employees contribute part of their salaries, and some employers can match it. Instead of getting a constant interest rate, you must invest your 401(k) savings into securities (stocks, bonds, ETFs, REITs, etc.) to earn a return. 401(k) accounts have three main benefits to encourage people to make contributions.

1. Any income contributed to a 401(k) is not taxed
2. Any returns generated on investments from your 401(k) are not taxed
3. Employers may match contributions either partially or fully

However, these benefits do not exist without caveats. The government does not want your 401(k) to be a better tax-free savings account (TFSA). Instead, the government puts certain restrictions and penalties on early withdrawals to encourage long-term investing for retirement. These penalties include the 10% withdrawal fee for an early withdrawal. In addition to the fee, the withdrawn amount is subject to income tax. The following table can help you understand whether you can withdraw money without any penalty.

The coronavirus pandemic has made buying a house much harder, so the IRS has exempted COVID-related hardship withdrawals from the 10% early withdrawal penalty. The taxable income can also be recognized over three years.

As an example of an early withdrawal penalty, suppose you need to withdraw $50,000 to cover the down payment. Because of the 10% penalty, the 401(k) balance will decrease by $55,000. Additionally, the $50,000 that have been withdrawn will be subject to income tax, so the owner of the account will have to also pay income taxes on these $50,000.

Can I use my 401(k) for a first time home purchase?

While the government discourages early withdrawals from your 401k, you can access the money in it using two different methods. You may either take out a 401(k) loan or make a 401(k) "hardship" withdrawal.

1. 401(k) Loans

A 401(k) loan is a "self-issued" loan, which means you borrow from your own 401(k) and repayments return to your account. Typically, the maximum loan term is five years, but this can be extended if the loan is used to buy a principal residence. With a 401(k) loan, you avoid the 10% early withdrawal penalty, and the amount will not be subject to income tax. The government does this because you have to repay yourself, so you are still saving for your retirement.

Advantages

1. Avoid early withdrawal penalties
2. The money returns to your account, and you continue to save for retirement
3. 401(k) loan debt is not factored into your Debt-To-Income (DTI) ratio
4. Failure to meet payments will not affect your credit score

Disadvantages

1. Must be paid back with interest (typically the Prime Rate + 2-3%)
2. No additional contributions during the loan term (interest payments are not contributions and are unmatched by your employer)
3. Failure to repay the loan turns it into a 401(k) withdrawal
4. Not offered by many 401(k) providers

2. 401(k) "Hardship" Withdrawal

If your employer does not offer 401(k) loans, they may still offer a 401(k) withdrawal.

For people under the age of 59½, a "hardship" withdrawal or early withdrawal from your 401(k) is allowed under special circumstances, which are on the IRS Hardship Distributions page. Using your 410(k) for a down payment on a principal residence is classified as a hardship withdrawal. By opting to use a hardship withdrawal, you will have to pay the 10% early withdrawal penalty, and this amount will be considered taxable income. Exceptions are on the official IRS page. Generally, these exceptions are difficult to qualify for, so a 401(k) loan is usually better.

The coronavirus pandemic has made buying a house much harder, so the IRS has exempted COVID-related hardship withdrawals from the 10% early withdrawal penalty. The taxable income can also be recognized over three years.

Advantages

1. You do not have to repay the amount
2. You can continue to make contributions
3. More widely available than 401(k) loans

Disadvantages

1. You will probably incur an early withdrawal penalty
2. The amount withdrawn will be taxed

How much can you withdraw from your 401k for a home purchase?

The maximum withdrawal amount varies depending on the method you use. Start with a 401(k) loan because it is the financially responsible choice. You can cover any remaining fees with a 401(k) withdrawal because of the 401(k)'s stricter loan requirements.

Due to a recent congress ruling, if your employer allows it, you are allowed to withdraw both your employer's 401(k) contributions and any investment earnings as well as your contributions.

Should you use your 401k for a home purchase

Your 401(k) should be the last place you look for down payment assistance. The government encourages you to keep money in this account to save for your retirement. Even with a 401(k) loan, you cannot make contributions for five years. The money in a 401(k) appreciates through investment returns. If you withdrew $20,000 out of your account today, with an annualized return of just 5%, you would be $86,000 poorer 30 years from now. There are also many other downsides associated with using your 401(k) for a home purchase:

• Early withdrawal penalties and increased taxable income
• Your 401(k) provider may charge you additional fees for early withdrawals or loans
• Since you cannot make contributions, you will lose out on any company matching programs that could double your contributions
• If you lose your job or quit, you will have to repay a 401(k) loan in full

Some homebuyers who cannot put a full 20% down payment are also offered an option to put less than 20% and take private mortgage insurance (PMI) instead. Since private mortgage insurance is paid by the borrower and protects the lender, many borrowers believe that they should avoid it at all costs. That is when they may think that it is better to withdraw money from their 401(k) instead of facing higher payments on the mortgage.

Even though sometimes it might be less costly to withdraw money from a 401(k), in many cases, it might be better to use PMI. PMI usually has an annual premium of around 0.5% to 1.5% of the principal amount. For example, a 1% PMI premium on a $300,000 loan is $3000 annually. It might sound like a lot, but PMI allows you to get a higher loan-to-value ratio. This means that the return on investment will be larger when using PMI instead of trying to find enough money to reach a 20% down payment. Additionally, the 401(k) tends to grow at a certain rate that depends on the investment portfolio in the account. An average growth rate of a market portfolio grows by 7% annually. Withdrawing the amount from 401(k) may lower the mortgage payments by around 1%, but you also do not earn interest of around 7% on the money withdrawn in addition to the 10% withdrawal penalty.

Alternatives to Using a 401(k) for a Home Purchase

You may not need a 401(k) loan or withdrawal to begin with. If your mortgage lender allows it, you can make a down payment of less than 20%. While a 20% down payment is standard, you only have to pay your minimum down payment. If your down payment is less than 20%, you get charged monthly Private Mortage Insurance premiums until you own 20% of your home's equity. Generally, paying for these premiums is better than taking money from your 401(k).

Before using your retirement funds to pay for a down payment, consider any alternatives you have available:

1. Savings and Investment Accounts (CDs, Stocks, Bonds, etc.)

Check any liquid assets you have available. Before getting a mortgage, make sure your income supports the monthly mortgage payments and that you have savings for emergencies. Check how much house can I afford calculator to help you determine your affordability.

2. Federal and State Government First-Time Home Buyer Programs

The federal government has many first-time homebuyer programs with lower minimum down payments and payment assistance programs. You should also check with your state's local housing authority because each state has unique first-time homebuyer programs. These government-backed mortgages include programs for first-time home buyers and programs that target specific demographics.

The most popular first-time home buyers program is the FHA loan. This loan is backed by the Federal Housing Administration. They require a minimum down payment of 3.5% and a credit score of at least 580. It is possible to get approved for an FHA loan with a lower credit score, but it will require a down payment of at least 10%. FHA loans also require private mortgage insurance until the loan-to-value ratio is below 80%. Other increasingly popular mortgage programs available are Freddie Mac Home Possible program and the Mannie Mae HomeReady program. They all focus on providing mortgage loans for households who may not be able to afford a 20% down payment for the house they want to purchase.

Other programs focus on specific demographics who may need assistance in purchasing a house. VA loans allow eligible veterans and service members to get a mortgage loan with no down payment. It also features low-interest rates and flexible mortgage terms. A USDA loan is another type of loan that allows people to pay less for a down payment. The main requirement for this type of loan is that the house must be located in a rural area. It also has to be used as a primary residence by the borrower, and the borrower has to earn low to median income.

3. Family and Friends

Getting a family gift can help you secure a down payment without having to take on unnecessary debt or compromise your retirement funds. This family gift cannot be a loan.

4. Personal Loans

Banks and other lenders will give you a personal loan if your creditworthiness is high. However, this will add to your Debt-to-Income (DTI) ratio, which may affect your mortgage conditions and eligibility.

5. IRA

If you have an IRA, there are special provisions for first-time home buyers. If you have not owned a primary residence in the past two years, you can withdraw up to $10,000 without incurring the 10% early withdrawal penalty (additional amounts have the 10% penalty). This amount will still be considered taxable income.

6. 401(k) Loan or 401(k) Withdrawal

Only after considering all the above options should you take money out from your 401(k). Your 401(k) should be your last resort because of both the penalties and lost retirement funds.

Disclaimer

While we try to be your #1 source for real estate and financial information, we highly recommend you consult with your financial advisor prior to making any investment, real estate, or financial decisions based on information on our site. Our content is for informational purposes only, and is not intended to provide financial, insurance, legal, accounting, real estate, or tax advice.

Any calculators or content on this page is provided for general information purposes only. Casaplorer does not guarantee the accuracy of information shown and is not responsible for any consequences of its use.

Can You Draw From a 401k for a House

Source: https://casaplorer.com/401k-withdrawal-home-purchase

Share this post