401(k) Withdrawal For Home Purchase: Can I Use a 401(k) to Buy a House?
JA
Summary:
While you can withdraw 401(k) funds for a home purchase, this often isn’t a smart idea, especially if you’re under 59½. Not only will you miss out on the money earned from compounding interest, but you’ll also incur stiff penalties and taxes, which could throw your retirement plans off course.
The idea of homeownership has long been part of the American Dream. But is cashing out your 401(k) a smart way to finance your dream home? In short, no. The penalties for early withdrawals from a 401(k) on top of the taxes you’ll owe make it an expensive strategy to take advantage of. And that’s not even considering the fact that you’re now depleting what should be a nest egg for retirement.
Let’s look at the 401(k) withdrawal rules, why withdrawing your retirement funds early isn’t the best idea, and what other financing options to consider when buying a house.
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401(k) withdrawal rules
If you’re planning to dip into your nest egg to finance your home purchase, it’s important to understand the basic 401(k) withdrawal rules.
According to the IRS, early 401(k) withdrawals mean taking money out of the account prior to reaching the age of 59½ and can come with a 10% penalty. The only exception to the penalty is if you have a heavy and immediate financial need, like significant medical expenses, and have no choice but to withdraw money from your retirement account.
If you make 401(k) withdrawalsafter turning 59½, you won’t need to pay any penalty fees. However, you’ll still have to pay income tax on the withdrawn amount.
IMPORTANT! Making early withdrawals should be an absolute last resort. Not only does this action result in tax implications and hefty penalties, but you can also substantially set back your retirement plans.
Pros and cons of a 401(k) withdrawal for a home purchase
Withdrawing funds from your 401(k) to buy a house is certainly tempting, but there are numerous drawbacks you must consider. Let’s take a look at the pros and cons.
Opportunity cost generally refers to the costs a company forgoes by investing in a different option, but it can also apply to individuals. Here’s an example to illustrate the opportunity cost of withdrawing your funds early:
Zac (who falls into the 22% tax bracket) withdraws $50,000 from his 401(k) at 35 years old. After paying income taxes and an early withdrawal penalty, he receives around $32,500 today. However, if he leaves this $50,000 in his 401(k) until he’s 65, the value of these funds could grow to over $380,000 — assuming a 7% annual rate of return.
Borrowing from your 401(k) account
Apart from directly withdrawing funds from your 401(k), you can also take out a 401(k) loan to fund your home purchase. Of course, you have to repay the loan with interest, but you’re essentially paying yourself back. The repayment period of a 401(k) loan will depend on your plan administrator, but it’s generally less than five years. The interest rate also varies, but it’s typically a point or two above the prime rate.
The IRS allows you to borrow 50% of your vested account balance or $50,000, whichever is less. For example, if you have $160,000 in your account, you can take out $50,000 — which is the lesser of 50% of your vested account balance of $160,000 ($80,000).
Though taking out a 401(k) loan might be better than incurring expensive penalties with early withdrawals, it’s still not the best way to fund your home purchase. Here’s why:
During the repayment period, your plan provider may not allow you to contribute to the 401(k) account, and the loan payments also wouldn’t count as contributions and receive tax advantages. Plus, if you leave your workplace before paying off the loan, you’ll have to repay the loan balance in full by the federal tax deadline that year. If you don’t, the employer will treat the loan as an early withdrawal, and you’ll have to pay income tax and a 10% penalty fee.
Pro Tip
Taking an early withdrawal from your 401(k) has serious consequences. Use an early withdrawal tax calculator to see the financial impact of withdrawing your retirement savings early to pay for a home purchase. Or, if you have questions on how to contribute or withdraw from your 401(k), try reaching out to an investment advisor.
Alternatives to using your 401(k) for a home purchase
Withdrawing money from your 401(k) to buy a house should always be your last resort. You could incur penalty fees and taxes and miss out on thousands of dollars in compounded interest. Here are some alternatives to look into before tapping your 401(k) account.
Delay buying a home
As frustrating as it may be to delay your home purchase to save for a down payment, it’s worth it when you consider all the benefits of keeping your retirement funds untouched. Not only will you have access to more funds when you need them, but you’ll also allow the power of compounding to work its magic. This way your nest egg can grow even more and you won’t have to sacrifice your living standards.
Pro Tip
If you’re having trouble saving money for a down payment, budgeting apps like Mint and Personal Capital are worth a try. They let you track every penny of your spending so you can see exactly where your money goes each month. You can also set financial goals for specific objectives and track your progress.
Tap your IRA
Not all retirement accounts have strict withdrawal rules and hefty penalty fees like 401(k)s. According to IRS Publication 590-B, you may be able to avoid the 10% early withdrawal penalty on up to $10,000 with traditional IRAs. However, this only applies if you use the funds to buy, build, or rebuild your first home.
If you have a Roth IRA, you can withdraw your contributions tax and penalty-free at any time since they’re made with after-tax dollars.
Explore low down-payment mortgage programs
If you qualify for low down payment loans, you won’t need to come up with large sums of cash upfront to purchase a home. Some of the most popular loan options are those run by the U.S. Department of Veteran Affairs (VA) or the Federal Housing Administration (FHA).
Compared to the 20% down payment sometimes required by traditional mortgage loans, FHA loans feature down payments of only 3.5% or 10% — depending on your credit score. Most VA loan borrowers can even close on a home without making a down payment. While the minimum down payment required may differ depending on the house you want and the program you apply for, it’s worth taking a look at these options.
FAQs
When can you withdraw from a 401(k) without penalty?
In certain cases, the IRS allows 401(k) account holders to withdraw funds penalty free. Financial hardship is one of those reasons and covers several situations where you don’t have other reasonable options to access required funds. This could include medical bills, tuition, funeral expenses, a down payment on your first home, etc.
To qualify for a hardship withdrawal, you must prove to your 401(k) plan manager and employer that you’re in a tight financial spot and genuinely need the funds.
How do I withdraw money from my 401(k)?
If you have no better alternative and would like to withdraw money early from your 401(k) account, send a withdrawal request to the plan administrator or talk to the human resources department at your workplace.
Not every employer allows early 401(k) withdrawals, so check with the HR department to see if this option is available. If it is, they’ll typically ask you to fill out paperwork and documents before sending you the requested funds.
Key Takeaways
- It’s generally not a good idea to withdraw from your 401(k) to buy a house, as you’ll be subject to taxes and penalty fees.
- Borrowing from your 401(k) is an alternative to directly withdrawing funds from the account, but it also has its own drawbacks.
- There are other options available that are better suited for financing a home purchase. These include low down-payment mortgage programs or tapping into another retirement account like an IRA.
- If you’re not in a rush to purchase a home, consider saving up for a down payment instead of cashing out your 401(k) funds.
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