How to Use Your Retirement Funds to Buy a House
Retirement accounts are money that’s being set aside for you to use in your golden years. And if you've been carefully saving, you might be wondering if it’s OK to tap those funds to use for something right now, like a home purchase, given that it’s an investment in its own right.
Looking at your retirement account balance might make you feel as though you have more money than you actually have coming in on a regular basis. That's why it's crucial to really consider whether using your 401(k) to buy a home for the first time is actually an option for you.
One of the most common type of retirement plans is the 401(k), which is often offered by companies to their workers. It provides an easy way to earmark some of your salary for retirement savings, along with the tax benefits that a 401(k) brings.
You’ll be setting aside money without paying taxes right now and then will pay the taxes when you withdraw it, which ideally will be when you’ re in a lower tax bracket than you are in now. In many cases, companies also match up to part of your personal savings, which is another reason that 401(k) accounts are so popular, since that’s essentially “free money.”
But those funds have been set aside specifically for your retirement savings, which means that if your plan allows you to withdraw it earlier, you’ll pay a penalty, along with the taxes you owe given your current tax bracket.
There’s usually the potential to borrow from it, though, which may be a better option. Let's study both options, and see which one, if any, could be what you need to become a homeowner this year.
Withdrawing money from your retirement plan to buy a house
The 401(k) withdrawals are generally not recommended as a means to buy a house because they’re subject to steep fees and penalties that don’t apply to 401(k) loans.
While a 401(k) withdrawal is technically unlimited, it is generally limited to the amount of the contributions you made to the account and can avoid penalties if it is classified as a hardship withdrawal, but it will incur income taxes.
If you take a 401(k) withdrawal before age 59½, you’ll have to pay:
A 10% “early withdrawal” penalty on the funds removed
Income tax on the amount withdrawn
For example, say you withdraw $20,000 from your 401(k) to cover your down payment and closing costs.
You’ll be charged a $2,000 (10%) early withdrawal penalty
And you’ll have to pay income tax on the $20K, which likely comes out to around $4,000-$6,000
That’s up to $8,000 gone from your retirement savings, on top of the initial withdrawal. The standard rules for 401(k) withdrawals are as follows:
Most 401(k) plans allow withdrawals only in cases of financial “hardship”
However, using the money to buy a primary residence often qualifies as a hardship withdrawal
You can withdraw only the money required to cover your immediate need
The money does not have to be repaid
Since the IRS considers 401(k) withdrawals income, withdrawing 401(k) money could bump some home buyers into a higher tax bracket. This could add even more to the cost of the early withdrawal.
Borrowing from your retirement plan to buy a house (loan)
The first thing you need to do here is check with your employer or HR department to see if your 401(k) plan allows loans.
Now, unlike a 401(k) withdrawal, a 401(k) loan is not subject to a 10% early withdrawal penalty from the IRS. And the money you receive will not be taxed as income.
The rules for using a 401(k) loan to buy a house are as follows:
Your employer must allow 401(k) loans as part of its retirement plan
The maximum loan amount is 50% of your 401(k)’s vested balance or $50,000, whichever is less
The loan must be paid back with interest (typically the prime rate plus 1-2%), on a schedule agreed to by you and your 401(k) provider
Typically, you cannot make 401(k) contributions while you have an outstanding 401(k) loan
It's important to note that 401(k) loans typically need to be paid back over five years. When the money is used to purchase a home, you’re usually allowed to pay it back over a longer period of time. Rules vary by 401(k) company, so check with yours to learn more.
Benefits of using your 401(k) to buy a house
Allowing you to make a purchase you might otherwise not be able to make
You might not be losing as much money on interest payments as you would if you got the funds via another means.
A 401(k) loan is usually not counted in your debt-to-income ratio, so it won’t hurt your chances of mortgage qualifying
401(k) loans are not reported to credit bureaus, so applying for one won’t harm your credit score
Cons of using your retirement funds to buy a house
There are a variety of drawbacks and risks involved in using a 401(k) to buy a house. These include:
If you decide to withdraw rather than borrow, you will pay a LOT of taxes, and I mean A LOT
Missing out on making new contributions while you pay yourself back if you borrow
Having to pay penalties, fees, and interest (sometimes at a higher interest rate) depending on the specifics of your company’s 401(k) when you borrow
Losing out on the compounding interest your money could earn if you left it in the retirement account
Missing out on your company’s match
Finding yourself in a bind if you change jobs and have to pay your 401(k) back in a lump sum
Your 401(k) account may seem tempting as an untapped source of cash, especially if you’re struggling to come up with the money for a down payment on your new home. While this is a viable option, and there are ways to mitigate the penalties, it should only be used as a last resort.
Consider applying for a low down-payment loan like an FHA or VA loan, or, if you have one, making a withdrawal from your IRA.
Let's schedule a call! I'll be happy to assist you in deciding whether this will be a smart move for you as a first-time home buyer.
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