A 401(k) plan is a valuable retirement account that can lead to a smoother financial journey after your career concludes. However, some people may want to tap into those funds for a home purchase. Using a 401(k) to fund some or all of a down payment can be a convenient choice. This guide will help you assess the pros and cons of using a 401(k) withdrawal for a home purchase so you can make the right decision for your finances.
What Is a 401(k)?
A 401(k) is a company-sponsored retirement plan that has higher annual contribution limits than an individual retirement account. The IRS periodically adjusts these limits and allows people who are 50 years or older to make additional catch-up contributions.
These retirement accounts have tax advantages. A traditional 401(k) plan uses pre-tax dollars. You then owe taxes when you withdraw funds. Roth 401(k) plans use post-tax dollars. You won’t avoid taxes this year, but you won’t owe any taxes on your capital gains or dividend payments. Both accounts let you withdraw funds penalty-free after you turn 59 ½ years old; they charge a 10% penalty on early withdrawals for non-qualifying expenses.
Can You Use Your 401(k) to Buy a House?
You can use a 401(k) to buy a house. The IRS allows first-time home buyers to avoid the 10% penalty fee for the first $10,000 withdrawn from a 401(k). You must use those funds to buy your first home to avoid the fee. You’ll incur the penalty fee for every dollar above $10,000 if you are not 59 ½ years or older. However, there are other ways to tap into your 401(k) funds without incurring a penalty.
How to Use 401(k) for Home Purchase
A 401(k) plan can help with retirement, but it can also assist with financial milestones in the present. These are two popular ways you can use a 401(k) retirement account to become a homeowner.
401(k) Loans
A 401(k) loan lets you borrow against the funds in your retirement account. Since you are borrowing your own funds, you usually don’t have to go through a credit check and can end up with a lower interest rate than other types of loans.
Any loan repayments plus interest go back into your 401(k) account. However, when you take out a loan, you also pull money out of your 401(k) plan. Those funds will not grow while you are paying off the loan. While you will have to contend with interest, you won’t end up with a 10% penalty.
Most 401(k) plans have five-year terms. A lengthier term results in lower monthly payments but also prolongs the amount of time the capital from the loan won’t grow in your account.
401(k) Withdrawals
These withdrawals have 10% penalty fees after the first $10,000. You won’t have to worry about any ongoing expenses, but your retirement account will grow at a slower pace. Withdrawing too much money from your 401(k) plan can put you back at square one. You’ll then have to work on rebuilding your account before retirement and hope that no other large expenses reduce your 401(k) funds.
Should You Use Your 401(k) to Buy a House?
Using a 401(k) to buy a house comes down to instant gratification vs. long-term growth. If you tap into your retirement account, you’ll immediately have the necessary funds to make a down payment. While that sounds good, you will end up with penalty fees or interest payments depending on how you tap into your funds.
Those extra expenses are bad enough, but it’s even worse when you consider how much money you could lose out on from having a lower balance. You lose that potential growth if you use your 401(k) to buy a house.
Assume an aspiring homeowner has a $100,000 balance in their 401(k). If this balance were to grow at a consistent 8% per year for 40 years, the balance would turn into $2,172,452.15. Although your investments aren’t guaranteed to earn that rate every year, if they did, it would be a solid nest egg that can help most people through retirement.
However, what if the same homeowner took $40,000 out of their 401(k) plan to buy a house, including penalty fees? The fund now only has $60,000 remaining. If the $60,000 balance grows at the same 8% rate for 40 years, the balance would be $1,303,471.29 after 40 years.
The balance is roughly $800,000 less than what the homeowner could have had. The decision to take out $40,000 early for a home could end up costing the homeowner in this example $800,000 in the long run. However, the equity in the home and its value could also grow during that time.
Alternatives to Using 401(k) for Home Purchase
A 401(k) is often not the best resource for raising funds to buy a home. It’s usually better to wait until you turn 59 ½ before you withdraw that money. These alternatives offer better value for aspiring homeowners.
IRA Withdrawal
These accounts are similar to 401(k) plans. You can still withdraw $10,000 before incurring any penalties. However, you are still tapping into funds meant for retirement. While IRA withdrawals are one alternative to consider, the next two choices on this list are better for most home buyers.
FHA Loans
FHA loans make capital more accessible with lower down payment requirements. You only need to make a 3.5% down payment to buy a property. These loans are also available for people with bad credit. You can still get a loan if your credit score is between 500-580. You will have to make a 10% down payment if your score falls within this range, while borrowers with credit scores above 580 can get loans with 3.5% down payments. A lower down payment can help you preserve your 401(k) funds.
FHA lenders will also look at your income to assess your ability to repay the balance. They’ll also look at your debt-to-income ratio which measures monthly debt payments as a percentage of your monthly income. These loans can have debt-to-income ratios as high as 57%. That’s more generous than the DTI limits for conventional mortgages. The maximum FHA loan term is 30 years.
VA Loans
VA loans are specifically for qualifying past and present veterans. Qualifying spouses of veterans can also use these financial products. Borrowers receive competitive rates and have the option to put zero money down. While no down payment will increase your monthly mortgage payments, you won’t have to touch your 401(k) funds to buy a house. The maximum VA loan term is 30 years.
Find the Best Mortgages from Benzinga’s Top Home Loan Providers
A great mortgage can keep your 401(k) funds safe and make homeownership more accessible. These are some of the top mortgage lenders that specialize in FHA loans, VA loans and other types of financing.
Protect Your 401(k) Account While Buying a House
A 401(k) plan can be a great resource for additional funds to buy a house. However, you don’t have to borrow from your 401(k) or make early withdrawals just because it’s an option. Using alternatives like FHA loans, VA loans and first-time home buyer programs can help you grow your retirement account while achieving the dream of homeownership.
Frequently Asked Questions
How much money can I withdraw from my 401(k) for a home purchase?
You can withdraw any amount of money for a 401(k) home purchase. The first $10,000 does not have penalty fees. However, you will have to pay income taxes on distributions from a traditional 401(k) and penalty fees for every dollar above $10,000.
Are there any penalties for withdrawing from 401(k) for home purchases?
You only pay penalty fees for every dollar after $10,000. The penalty fee is currently 10% and doesn’t include income taxes for traditional 401(k) plans.
What happens if I am unable to repay a 401(k) loan taken for a home purchase?
The unpaid balance becomes a plan distribution. You won’t have those funds added back to your 401(k) plan.