Can I Use My 401(k) to Buy a House?

What Is a 401(k)?

A 401(k) is a retirement savings plan offered by many employers. The employee agrees to have a percentage of each paycheck paid directly into an investment account. They may choose from options like mutual funds, government bonds, and index funds. The employer may match part or all of that contribution.

There are two types of 401(k)s—traditional and Roth. They differ primarily in how they’re taxed.

• Traditional 401(k): Employees contribute funds before taxes are deducted. It means that they reduce taxable income, but the withdrawals are taxed.
• Roth 401(k): You pay taxes on the contribution before placing it into the account. You don’t pay any taxes after withdrawal.

Can You Use 401(k) to Buy a House?

Yes, you can use your 401(k) to buy a house. However, there are some things to consider before doing so. If you withdraw funds from your 401(k) before the age of 59½ years, you will incur a 10% penalty.

However, there are 2 ways in which you can avoid this penalty:

401(k) Loans

To get a 401(k) loan to buy a house, you need to follow these steps:

1. Check if your employer’s 401(k) plan allows loans. Not all plans do.
2. Determine the maximum amount you can borrow. It is the greater of $10,000 or 50% of your vested balance, up to $50,000.
3. Fill out the loan application form provided by your 401(k) plan administrator.
4. Wait for the loan to be approved. This usually takes a few days.
5. Once the loan is approved, you will receive the funds in your bank account.
6. Use the funds to buy the house.

A 401(k) home loan is subject to certain conditions:

• You must repay a 401(k) home loan with interest, usually within five years.
• If you leave your job before the loan is repaid, you may be asked to repay the entire loan amount immediately.
• Failure to repay the loan on time may result in an additional penalty.

You can approach your 401(k) provider to understand the loan premiums, terms, and conditions.

401(k) Withdrawals

You will likely be penalized if you withdraw all your 401(k) funds before the age of 59½ years. Taking more than $10,000, or using your 401(k) funds to leave your current home to buy a new one will trigger the tax.

Further, the amount you withdraw will be taxed as income. However, you can avoid penalties if your withdrawal is classified as a hardship withdrawal.

Qualified first-time homebuyers can take up to $10,000 from their retirement account without paying the 10% early distribution tax.

What Qualifies as a 401(k) Hardship Withdrawal for Home Purchase?

The IRS defines hardship withdrawal as a distribution made from the 401(k) account because of an immediate and heavy financial need. Accordingly, it specifies three types of expenses that can qualify for this withdrawal:

1. To buy a primary residence.
2. Payments necessary to prevent eviction from primary residence or foreclosure.
3. Expenses to repair damage to the primary residence.

CARES Act 401(k) Withdrawal for Home Purchase

The US Congress passed the CARES Act in March 2020 to provide relief to individuals and businesses affected by the COVID-19 pandemic. The Act allows qualified individuals the following benefits:

• You can borrow up to $100,000 or 100% of your vested balance, whichever is less.
• The 10% early withdrawal penalty is waived.
• The amount is spread over 3 years for income tax purposes.
• You get 3 years to repay the borrowed amount and undo the tax consequences.

However, this law is applicable only as long as the individuals are eligible for coronavirus-related distributions. The IRS defines these distributions as ones made to qualified individuals between January 1, 2020, and December 30, 2020.

Pros and Cons of Using 401(k) to Buy a House

You need to weigh these pros and cons before tapping into your 401(k) funds:

Advantages

• Lower Interest Rates: Using your 401(k) funds to make a down payment on a home can help you secure a lower interest rate on your mortgage.
• No Credit Check: You don’t need to undergo a credit check to withdraw funds from your 401(k).
• No Loan Application Process: Unlike a mortgage, there is no loan application process for a 401(k) withdrawal for a home purchase.

Disadvantages

• Less Money for Retirement: Your long-term financial security is affected if you get an early withdrawal.
• Penalties and Taxes: If you withdraw all your 401(k) funds, you will face a 10% penalty. However, you can avoid this penalty if your withdrawal is classified as a hardship withdrawal.
• Opportunity Cost:  If you use your retirement funds to buy a house, you lose out on the compounded interest that would’ve accrued in your 401(k) account.

How Does Using Retirement Funds to Buy a House Affect Your Expenses?

A 401(k) nest egg during your old age helps you live comfortably. Let’s take an example to understand your income and expenditure with and without a 401(k) plan.

On average, people aged 65 and up spent about $52,141 annually. A retiree receives $29,072 in social benefits yearly. With an income solely coming from social security, you’d fall short of $23,069 per year. And that’s excluding taxes.

On the other hand, consider you have a traditional 401(k) plan with $500,000 in it. You withdraw $3,000 monthly and also get the average social security benefit. That brings your income to $65,072. You’ll pay $10,309 in taxes, taking into account the 22% federal tax and standard deductions.

That brings your annual income to $54,763. If you reduce the average annual expenditure from it, it leaves you a surplus of $2,622.

Alternatives to 401(k) Loans for Home Purchase

There are several alternatives to using your 401(k) to buy a house. Here are some of them:

1. Individual Retirement Account (IRA): You can save money in an IRA account with tax-free growth and a tax-deferred basis. To buy your first home, you can withdraw up to $10,000 from your IRA account without a penalty.
2. Saving for a Down Payment: This involves setting aside funds over time until you have enough for the upfront cost of a home.
3. Acquiring a Mortgage Loan: This is a loan that a bank provides specifically for buying a house. Mortgage loans help you spread the cost over many years.
4. Government-assisted programs: Programs like FHA loans and VA loans aim to make homeownership more accessible. It offers zero down payments and lower interest rates.
5. Private investor loans: These are suitable for those who want to buy a house with lower credit scores. These loans are typically subject to higher interest rates.
6. Rent-to-own options: Rent-to-own is a home-buying option that allows you to rent a property before opting to purchase it for a specified price.
7. Shared equity financing: This allows an investor to share the home’s purchase price in exchange for a stake in the property’s future value. It reduces initial costs and the mortgage loan size.

It’s important to note that each of these alternatives has its benefits and risks. You should consider your financial situation and goals before deciding which option is best for you.

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Bottom Line: Can I Use My 401(k) to Buy a House?

If you use your 401(k) for a home purchase, it’s important to consider the long-term impact on your financial security. You should weigh the benefits of potentially lower interest rates against the opportunity cost of reduced retirement contributions. It is crucial to approach a financial advisor before you use your 401(k) to buy a house.