With interest rates at record lows, many people are trying to become first-time homeowners right now. However, changing your homeownership timeline can turn into a problem if you don’t have enough money saved for a down payment. For those with a sizable 401k, it can be tempting to want to use those funds to buy a house. While this is usually possible, it doesn’t always mean it’s a good idea. We highly recommend you talk to an expert like Alex Scurr from the video above, before making any big decisions. To contact Alex, please click HERE.
A Quick 401K Breakdown
Your 401k is a retirement plan where your money can grow tax-free. However, to avoid any monetary penalties, you can’t withdraw your money until you’re 59 1/2. You get to choose what percentage of each paycheck you want to invest in your retirement. The money is withdrawn from your paycheck pre-tax. Therefore, you won’t owe any tax money until you start to withdraw at retirement age. Withdrawing before then can lead to an early withdrawal penalty plus additional income taxes. However, there are some exceptions.
Borrowing from Your 401K
When borrowing from your 401K you don’t have an early withdrawal fee and you don’t have to pay income taxes on the money you withdrew. Think of this strategy as a loan from yourself, to yourself. Just like a regular loan, you will need to pay yourself back, plus interest. Usually, you will need to pay back your account within about five years, but this time frame can vary.
The consequence though, is that your repayment deposits don’t count as contributions – so you don’t get a tax break. When borrowing you can usually take out half of your vested account balance or $50,000. It depends on which has less money.
Pro Tip: Just because you’re borrowing from yourself doesn’t mean you’re not taking on debt. In the eyes of a lender, you may no longer qualify for certain mortgages or rates.
Withdrawing from Your 401K
If your 401k provider doesn’t allow borrowing from your 401K or you need more than $50,000, you will have to withdraw from your account. You will incur the 10% withdrawal fee and have to pay income taxes on top of that. Unlike borrowing, you don’t have to pay this money back.
If you are under the age of 59 1/2, you are allowed one “hardship” withdrawal in certain circumstances such as buying your first home. With a hardship withdrawal, you are allowed to take out $10,000 and avoid the 10% penalty fee, but you still have to pay income taxes.
Pros and Cons
The number one thing you want to avoid at all costs is irreparably hurting your retirement funds. You don’t want to end up like the millions of Americans who are concerned about being able to retire when they want to. While building equity in a home is a worthwhile endeavor, don’t forget that your 401k grows based on how much money you have. The more money you invest, the more money you can earn, and you don’t want to miss out on any of those earnings.
Using your 401k to buy a home can be worth it if you expect to pay off the loan in less than a year. Your risk is reduced if you know you’ll be coming into money through a raise or a bonus. If taking money out of your 401k eliminates the need for private mortgage insurance and you can pay it off, that’s even better.
Pro Tip: Sometimes you can’t contribute to your 401k if you are still paying back the money you borrowed. This means you not only lose out on potential investment earnings, but you can miss out on employer contributions as well.
Want to Hear the Other Options?
A Roth IRA is a different form of tax-free retirement savings. Like a 401k account, IRAs also have exceptions for withdrawing money, including when buying a home. Unlike a 401k, you can withdraw any money any time because you pay taxes when contributing to the account, not when withdrawing. If you are under 50, you may contribute up to $6,000 in your Roth IRA this year. If you are over 50, you can contribute an extra $1,000. If you’ve maxed out your contribution for the year, you can withdraw up to $10,000. As long as you’re using it to buy a home for the first time, you can avoid the 10% penalty. However, just like with the 401k withdrawal, it’s not always a good idea to take money out of retirement accounts.
If withdrawing from your 401k or Roth IRA doesn’t sound appealing to you, we have another option! There are many down payment assistance programs you can use to your advantage and leave your retirement money in place. We recently hosted a webinar with a mortgage lender aimed specifically towards first time home buyers. Click here to watch our webinar on down payment assistance programs and how you can partake in them.
Buying your first home can be overwhelming and that’s why you need experts on your team! If you have any questions about buying or selling, or need a recommendation for a mortgage broker, we’re here for you. As local Long Beach experts, we can send you to the right people and help you with your real estate journey. Fill out the form below to get in touch with us.