“401(k) Withdrawal Rules and Home Buying: What You Need to Know”

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401(k) Withdrawal Rules

If your savings for a new home are short of your goal, you may be considering using funds from your 401(k), especially if it holds sufficient funds to meet the down payment for your dream home. But can you pull money from your 401(k) to buy a new home? Yes, you can use a 401(k) to buy a house, but whether you should depends on the amount you have saved, potential penalties for early withdrawal, and your financial situation.

401(k) Withdrawal Rules

While most 401(k) plans allow you to use 401(k) funds as a house down payment, doing so may lead to tax implications. That’s because withdrawing money goes against the main purpose of a 401(k): saving for retirement. The IRS even incentivizes you to set aside enough money for retirement by offering tax advantages for both traditional and Roth 401(k) contributions:

• Traditional 401(k): Your contributions are made pre-tax, which reduces your taxable income, while withdrawals in retirement are taxed as regular income.
• Roth 401(k): Your contributions are made with after-tax income and grow tax-free. Roth 401(k) withdrawals made during retirement are also tax-free.

The IRS allows you to make penalty-free withdrawals from your retirement accounts once you reach age 59½. With few exceptions, making withdrawals before age 59½ will subject you to a 10% early withdrawal penalty. Additionally, withdrawals from a traditional 401(k) are taxed as regular income, but that’s not the case with Roth 401(k) withdrawals since your contributions are taxed upfront.

How to Use Your 401(k) to Buy a House

If saving up enough for a down payment is an obstacle to buying a home, tapping into your 401(k) is one option to help you reach your goal. If your retirement plan allows it, you can take out a 401(k) loan or directly withdraw funds from your account. Each method has its own benefits and downsides to consider.

1. Get a 401(k) Loan

Applying for a 401(k) loan is likely your best option because of the benefits it provides:

• Avoid the 10% early withdrawal tax penalty: Since you’re essentially loaning money to yourself, you shouldn’t incur any tax penalties, and the borrowed amount won’t be taxed as regular income.
• It doesn’t factor into your debt-to-income ratio (DTI): DTI is the amount of your total monthly debt obligations compared with your total gross monthly income. Most lenders look for a DTI ratio of less than 43% to qualify for a mortgage, while some prefer even lower DTI ratios below 36%. Any debt you owe your 401(k) plan after a loan won’t be added to this calculation.
• It won’t affect your credit score: Your credit score doesn’t come into play with 401(k) loans. You don’t need a credit score to qualify for a 401(k) loan, and the loan will have no bearing on your loan approval odds.

Retirement plans vary by employer, but the most you can borrow from your 401(k) is $50,000 or half of your vested balance if it’s below $100,000. Some plans provide an exception and allow you to borrow up to $10,000 even if your vested balance is lower than this amount.

Generally, 401(k) loans must be repaid within five years at an interest rate set by your 401(k) plan administrator, usually 1 or 2 percentage points higher than the current prime rate. Keep in mind, you’re effectively paying yourself back with interest. But if you leave your job before you’ve repaid the loan, the loan’s due date accelerates to the next income tax filing deadline.

2. Withdraw From Your 401(k)

As mentioned, withdrawing money from your 401(k) to purchase a home isn’t ideal because you must pay a 10% early withdrawal penalty and pay income taxes on the amount if you make the withdrawal before age 59½.

The IRS does provide exceptions to early withdrawal penalties, but they are intentionally difficult to qualify for. Early withdrawals, classified as hardship withdrawals, are intended for tackling an immediate financial crisis like medical bills, tuition fees and, yes, even down payments and other costs related to purchasing a primary residence.

But to qualify for the loan, you’ll need to provide proof of financial hardship to your plan administrator and show the IRS you have no other available assets to buy a home in order to qualify for the early withdrawal penalty exception.

Should You Use Your 401(k) to Buy a House?

In some situations, using money from your 401(k) may be worth it to buy a home. For example, if taking out a 401(k) loan enables you to qualify for a lower mortgage rate or sidestep private mortgage insurance (PMI) costs, it could be worthwhile. Run the numbers for your unique situation to ensure the move makes financial sense.

However, using money from your 401(k) before retirement generally isn’t the best idea for several reasons:

• Early withdrawal penalty and taxes: Unless you’re at least 59½ years old or qualify for an exception, you’ll have to pay a 10% penalty and taxes on any amount you withdraw. You can avoid penalties and taxes by taking out a 401(k) loan.
• Repayment risks: If you have a 401(k) loan and are laid off or quit your job, the amount will be due on the next income tax deadline date. If you don’t have a new job or source of income, repaying the loan could be challenging.
• Opportunity cost: The money you withdraw from your retirement account no longer has a chance to grow, and you could miss out on years of investment growth. Even if you get a 401(k) loan, the time you spend paying back the loan could be better spent growing your retirement.

Alternative Ways to Buy a House

Accessing your 401(k) is one way to come up with funds to purchase a home, but it’s not the only method. Consider these alternative strategies to buy a house before making a decision.

• FHA loan: FHA loans allow minimum down payments as low as 3.5% if your credit score is at least 580. If your score falls below that threshold, the down payment minimum is 10%.
• VA loan: Like FHA loans, VA loans are also government-backed and typically have lower interest rates. If you’re eligible, you can get a VA loan with no down payment, and you won’t need to pay PMI, potentially saving you hundreds of dollars on your monthly mortgage payment.
• Down payment assistance programs: Many national and local programs are available to first-time homebuyers to help them come up with the necessary down payment. These programs, typically run by lenders, government agencies and local organizations, offer varying forms of down payment assistance ranging from grants and low-interest loans to forgivable second mortgages and deferred-payment loans.
• IRA account: Pulling from your IRA is usually better than withdrawing cash from your 401(k) for eligible first-time homebuyers. That’s because qualified first-time buyers, or anyone who hasn’t purchased a primary residence in at least two years, can withdraw up to $10,000 without being subject to the 10% penalty. The amount may still be subject to income tax unless it’s from a Roth IRA you’ve held for five years because these accounts hold after-tax contributions.

Improving Your Credit Can Save You Money

Using your 401(k) to buy a house may make sense in some scenarios, especially if it’s your only option. The more money you can apply to your down payment, the less you’ll need to borrow, potentially lowering your monthly payment and the interest rate you’re eligible for.

Another way to qualify for lower interest rates is to maintain a solid credit score. The higher your credit score, the better your loan approval odds and the likelihood of securing a low mortgage rate. Even a slight interest rate reduction could save you thousands of dollars over the course of your loan term.

As such, taking steps to improve your credit before you apply for a mortgage is essential. Start by checking your credit report and credit score for free with Experian. Review your report to identify any issues which may harm your credit and, if possible, take steps to resolve them.

For any mortgage service needs, call O1ne Mortgage at 213-732-3074. We are here to help you make the best financial decisions for your future home.

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