Should You Use a 401(K) When Buying a House?
Buying a house can be a great investment, but it’s also expensive. There’s the cost of the property and ongoing monthly payments.
In addition, there are out-of-pocket expenses associated with getting the actual mortgage.
Nowadays, many home loan programs require down payments that range from 3 percent to 5 percent of the sale price.
Buyers are also responsible for their own closing costs. This is an extra 2 percent to 5 percent out-of-pocket.
If you don’t have enough in personal savings, the good news is that you might be able to get your hands on funds.
If you have a 401(K), you can tap this account and use these funds for your down payment and closing costs.
But, should you?
Here’s how using a 401(K) when buying a house works, and what you can expect from the process.
How Does Using a 401K for a House Work?
A 401(K) is an employee-sponsored retirement account.
Once you’re eligible to open one, you can contribute a percentage of your earnings to the account.
As an employee benefit, your employer might match your contributions up to a certain percentage. This can maximize your growth and earnings.
Opening a 401(K) early in life contributes to a sizable retirement account. Since the purpose is to grow your account, it’s recommended that you leave the money untouched. Yet, you’re allowed to withdraw cash from your account.
People tap their retirement accounts for various reasons, with buying a house being a common reason.
You can either withdraw money for your 401(K), or get a 401(K) loan.
Getting funds typically requires filling out a form, making the process easier and faster than getting a personal loan.
Rules for Withdrawals Toward a Home Purchase
If you tap your 401(K) when buying a house, one option is to withdraw money from this account.
Needing cash to buy a home falls under the “hardship withdrawal rule.”
Under this rule, you can withdraw funds from a 401(K) to pay for medical expenses, funeral expenses, and repairs to your principal residence due to a fire, earthquake, or flood.
You can also withdraw cash to pay college tuition for up to 12 months, and buy a principal residence.
Some employers only allow hardship withdrawals for a home purchase when you don’t have other funds or assets to cover this expense.
But while funds are available for a home purchase, you must follow specific rules.
For example, if you’re younger than 59 1/2, withdrawing cash from your 401(K) will result in a 10 percent early withdrawal penalty. You’ll also pay income tax on the early withdrawal. This reduces the amount you actually receive. Plus, a withdrawal could push you into a higher tax bracket.
Another important thing to keep in mind is that you’re not allowed to repay a withdrawal.
So, not only will you reduce the balance of your retirement account, you’ll also miss out on years of compounding interest on this balance or growth.
Smart Way to Use a 401(k) When Buying a House
If you’re using a 401(K) early withdrawal to buy a house, it’s important that you only borrow what you need.
Being mindful, though, that you might have to borrow a little more to compensate for the 10 percent early withdrawal penalty and income taxes.
To illustrate, let’s say you need $10,000 to buy a house. If you withdraw this amount, you’ll likely only receive $7,000 after the penalty and taxes. In which case, you would have to pay the additional $3,000 needed for mortgage-related expenses out-of-pocket.
Instead, it might be better to withdraw $14,000. This will cover the early withdrawal penalty and income taxes, leaving you with about $10,000 for the home purchase.
To reduce the amount withdrawn from a retirement account, one option is saving up some cash for the home purchase, and then borrowing a smaller amount from your 401(K).
Using the above scenario, you might use $5,000 cash from a liquid savings account, and borrow $5,000 from your retirement account.
When should you start the withdrawal process if using this account to buy a home?
In most cases, it can take up to a week to get funds from an early withdrawal.
So, you’ll need to withdraw the money at least one to two weeks before closing.
Speak with your loan officer for advice on when to initiate the early withdrawal. Withdrawing the money too late could delay closing.
Also, get an idea of how much you’ll need for closing to ensure withdrawing enough. Three days before closing, you’ll receive your Closing Disclosure form.
This includes information on your exact mortgage terms, including the amount you’ll need at closing.
However, your loan officer might be able to provide down payment and closing cost information sooner.
Is a Withdrawal Different From a 401(K) Loan?
Be mindful, too, that a 401(K) early withdrawal is different from a 401(K) loan.
With an early withdrawal, you don’t repay the money to your retirement account. You do repay a 401(K) loan—with interest.
The good news:
You’re paying interest back to your own account.
A 401(K) loan might be a better alternative because you’ll avoid the 10 percent early withdrawal penalty and income tax—but only if you repay the loan.
If you leave your job for any reason before paying back the loan, you’ll have to repay any outstanding balance by the federal income tax return due date.
If you can’t pay the full balance, the loan becomes a distribution. At this point, you’ll have to pay taxes and the early withdrawal penalty.
You can, however, borrow up to $50,000 or half the value of your account, whichever is less.
In most cases, you’re given five years to repay the loan.
Your employer might not allow additional contributions until you’ve paid off the loan.
If using a 401(K) loan to buy a house, you must disclose this loan to your mortgage lender.
Alternative to Using a 401(K) When Buying a House
Although a 401(K) is a great way to get your hands on cash for a home purchase, it isn’t the only option available to you.
Given how an early withdrawal can result in a 10 percent penalty and income tax—and you’ll miss out on years of compounding interest—consider other options, too.
Only touch your 401(K) as a last resort.
1. Use an individual retirement account (IRA)
Another option is to withdraw money from an individual retirement account, or IRA. Similar to a 401(K), you’ll pay a 10 percent early withdrawal penalty and income tax on the withdrawal.
The difference, though, is that first-time homebuyers can withdraw up to $10,000 without paying the early withdrawal penalty.
You're considered a first-time homebuyer if you haven't owned a principal residence in the past two years.
2. Gift funds
Depending on your mortgage program, you can also use gift funds from an approved donor to pay your down payment and/or closing costs.
Approved donors typically include family members such as parents, grandparents, and siblings. Some programs do allow gifts from uncles, nieces, nephews, cousins, and godparents.
If you’re getting a conventional home loan, all of your down payment can come from a gift—if it’s at least 20 percent. If it’s less than 20 percent, you must contribute 5 percent of your own funds.
With an FHA and VA loan, your entire down payment can be a gift, if you have a credit score of 620 or higher.
If you have a lower credit score, your lender may require a contribution from your own funds.
3. Down payment assistance programs
Another option is to ask your loan officer about down payment assistance programs.
You might qualify for a local or state home buying grant for first-time homebuyers.
Or, your mortgage company may offer portfolio loans that don’t require a down payment.
These loans aren’t sold on the secondary market. So banks have the flexibility to adjust their down payment requirements.
The problem with no down payment loans is that they typically require an excellent credit score and come with higher interest rates.
A 401(K) can provide the cash you need to purchase a home sooner rather than later.
You can take advantage of home prices and mortgage rates before they increase.
But if you’re using this option, it’s important that you understand the price—whether you choose a 401(K) withdrawal or a loan.
Not only is there an early withdrawal penalty and income tax, but you could also lose out on years of compounding growth.