How to Use a 401(k) to Buy a House?
Find out how you can use money from your 401(k) to buy a house and what some drawbacks might be to dipping into your retirement savings.
When it comes to buying a new house, it can be difficult to come up with enough cash to cover the down payment and all the closing costs. If you are in this position, you may be wondering if you can use your 401(k) to buy a house. This seems like a decent plan, you have the money saved in an account, and you don’t plan on using it for several years. However, it is important to remember that there are strict rules and penalties that restrict access to the money in a 401(k) account prior to retirement. Despite that, there are still two options available: 401(k) loans and 401(k) withdrawals.
Making an early withdrawal from your 401(k) account should try to be avoided if possible. This is because any early withdrawals are subject to a 10% early withdrawal penalty as well as income taxes. However, some 401(k) plans do not allow 401(k) loans, so a withdrawal may be your only option.
Keep in mind that you will need to withdraw enough money to cover the 10% penalty and the income taxes. So, if you need $10,000 for your down payment, you will need to withdraw $12,500. Then you will pay the penalty of $1,250, which means you will lose a total of $13,750 from your 401(k).
It is possible for the withdrawal to qualify as a “hardship” withdrawal, which allows you to take money from your 401(k) without having to pay any penalty fees. These are used to cover a one-time immediate, emergency expense. The IRS does recognize the purchase of a primary residence as a potential “hardship” expense, but it is ultimately up to the 401(k)-plan provider to determine what qualifies as a “hardship” under your specific plan. Therefore, your 401(k) plan must decide what qualifies as a “hardship” withdrawal and what evidence is needed to qualify.
Even if you are able to avoid the 10% penalty with a “hardship” withdrawal, you will still have to pay the 20% in taxes on any money to take out of your 401(k).
401(k) loans are usually a more favorable option because you can avoid the 10% withdrawal penalty. 401(k) loans are also not subject to income tax like an early withdrawal is. However, keep in mind that if you do not repay your loan within the given time frame, it will then be considered a taxable withdrawal.
In order to determine if you can borrow from your 401(k), you will need to consult your employer’s HR department or your 401(k)-plan provider. Your employer will have to approve the loan, but they are not required to do so. If you are allowed to borrow from your 401(k), you can borrow half of the total amount in your 401(k), up to $50,000. You will also have to find out what the interest rate is, as well as the repayment period.
Remember that you will have to pay your 401(k) loan back with interest, and while payments will be going back into your retirement, loan payments do not get the same tax breaks as contributions, nor will there be an employer match. Many 401(k) plans will not allow you to make contributions to your account until the loan is completely repaid. Normally, loans must be repaid in five years, but if the loan is used to purchase a principal residence, the repayment period may be longer.
As long as you remain employed with your company and continue to make your payments on time, you will be able to avoid the 10% penalty and income tax than an early withdrawal would be subject to. But, if your employment ends, the loan will be considered an early distribution and will then be subject to the 10% penalty and ordinary income tax.
Downsides to Using Your 401(k) to Purchase a House
The biggest downside to using money from your 401(k) for a home purchase is that it significantly diminishes your retirement savings. Even if you pay back the money that you borrowed over time, it will not experience the same amount of growth that it would have if it was never withdrawn.
For example, if you have $50,000 in your 401(k) account and it experiences 6% annual returns, in 30 years that amount will grow to $287,175. But if you take $20,000 out to purchase a house, leaving only $30,000 in your 401(k), in 30 years that amount will only be $172,305. Removing that $20,000 cost you over $100,000 in the long run.
Alternatives to Using Your 401(k)
If you have plenty of time before you plan on buying a house, it may be a better option to try to save up for the down payment so that you don’t have to dip into your retirement savings. It could even be better for your retirement savings to stop your 401(k) contributions for a couple of years so that you can save up for the down payment on a house and avoid taking any withdrawals from your retirement savings. This way, your 401(k) can continue to grow even if you briefly stop contributing.
Another alternative to using your 401(k) is to use an IRA. If you do have an Individual Retirement Account (IRA), you should know that the IRS allows you to take up to $10,000 from your account to purchase a house without any penalty. If you do not have an IRA, you can rollover your 401(k) funds into an IRA, but this is only possible if you are no longer employed with the company that provided your 401(k) plan.