If you’re short on cash for a down payment, and you happen to have a retirement plan at work, you might be wondering if you can use a 401(k) to buy a house. The short answer is yes, you are allowed to use funds from your 401(k) plan to buy a home. It is not the best move, however, because there is an opportunity cost in doing so; the funds you take from your retirement account cannot be made up easily. Here’s a look at the details of tapping your 401(k) for the joys of homeownership, along with some better alternatives.
What is a 401k?
The 401(k) plan is a retirement plan for your company. Most large employers offer at least one type of 401(k), either a traditional or a Roth 401(k), but your company can and most likely will have multiple options. Let’s say your company offers a traditional 401(k) plan. Traditional 401(k) plans have a high contribution limit. If you were an employee of a company that offers a 401(k) plan, you could put up to $18,000 in a traditional 401(k) account during the 2018 tax year. The downside is that there is a lot of paperwork and management overhead in a traditional 401(k) plan. A traditional 401(k) plan gives your employer a larger portion of your money, all the way up to 50% in most cases.
How does 401k work?
One of the first questions most people have about tapping into their 401(k) plan is how does it work? This is really a very simple process. It is similar to the “regular” way of setting up an Individual Retirement Account (IRA), where you set up an investment account that earns a little bit of interest every year. The difference with the 401k, however, is that your 401(k) account cannot normally be touched until retirement. So, the good news is that you can leave your 401(k) money invested in a brokerage account, and pull some money out whenever you feel like it. The bad news is that you are then no longer in a position where you can use those funds for a major purchase like a home. That is until you take money out early and then put it back in.
Can you use your 401k to buy a house?
The short answer is yes, you are allowed to tap your 401(k) plan to buy a house, but you should only do so as long as you have the funds to do so. If you don’t have enough to buy a home, it’s not really an option. That said, your 401(k) plan is a good asset class for purchasing a home. The general rule is that you can only tap the 401(k) funds to buy real estate if you have access to the down payment amount in cash, or if you have enough money to get a 30-year fixed-rate mortgage. If your plan allows, you can tap the 401(k) account to buy a home, with the caveat that if you don’t have enough saved, you’ll be rolling the dice. While your 401(k) doesn’t have a custodian (your employer must manage it), it still offers a lot of investment choices.
This post contains affiliate links. Please please read my Disclaimer for more information
A 401(k) loan, also called a loan from a retirement account, is a temporary loan that is usually paid back after you are finished working for the company. It can be used for a variety of different purposes. You can borrow money for a car, purchase a second home, go on vacation, or if you don’t mind taking a risk, you can get a mortgage on your new home with the help of a 401(k) loan. However, there are two potential downsides to borrowing from your 401(k): You can only use the money you take out of your 401(k) for one purpose at a time. This means that if you need to use your 401(k) to get an early mortgage payment on your house, you won’t be able to take advantage of other options like refinancing or selling your home.
Money withdrawn from your 401(k) retirement account can be used only to buy a home, not to pay taxes on that money, or to pay for other things, such as closing costs. You have to pay the IRS a 10% penalty on withdrawals made before age 59½, so it’s better to hold on to the funds until you are ready to actually purchase a home. You cannot take out money for living expenses, but you can pay for medical expenses or college expenses without an additional penalty. These provisions do not apply to Roth 401(k)s, so don’t expect to have to pay taxes on the money you take out for these purposes.
Drawbacks to Using Your 401(k) to Buy a House
The biggest cost is the higher taxes you have to pay on the income from the home loan. The good news is that you can eliminate the need to worry about the tax bite by making sure you’ve started building an emergency fund before doing anything else. It is also important that you diversify the types of investments you have in your retirement account. The bigger drawback to using a 401(k) is that you’ll need to contribute up to $10,000 to a retirement account in order to buy a house. This is because the maximum you can contribute to a 401(k) every year is $18,000, and a 401(k) account is not free. It takes money to build one, so you will have to pay at least $1,000 (your $10,000 in contribution) in fees to keep the account active.
Alternatives to Tapping Your 401(k)
The key point about using a 401(k) to buy a house is that you’ll have to pay income taxes on the amount. So if you make $100,000, you will be paying approximately $16,000 in income taxes. This is money that could have gone toward your retirement.
Find The Mortgage Option That’s Right For You
Before going down the road of using your retirement plan to buy a house, it’s important to first take a look at whether your 401(k) could be tapped for other purposes such as a second car, a college education, or even some non-necessities like vacations and hobbies. For example, if your employer offers a matching program, it’s usually easiest to invest in an IRA, which you can only do if you’re younger than age 50. If the option to tap a 401(k) is the only realistic way for you to purchase a home, there are other ways to save for a down payment without missing out on other financial goals.
What is the cost of using 401(k) for a house?
How much you need to contribute toward a home purchase varies by household. For many first-time buyers, a simple rule of thumb is to save 15% of the home price. The other 10% should go toward closing costs. According to bankrate.com, the average home sale price in July was $266,000 in the U.S. Fees to buy a home Over the course of a 30-year mortgage, if you were to pay 0% interest and the 10% of a $267,000 home cost would cover the balance, you would end up paying $110,000. Assuming a 6% interest rate, that equals $7,167. Applying the cost of the down payment to 0% for a 30-year loan equals $4,962, which means you would need an extra $12,216 to put toward your down payment. As the cost of a home goes up, it becomes more difficult to save enough for a down payment.
It’s important that you understand all of the potential ramifications and tradeoffs that come along with taking money from your 401(k) to buy a home. Using a 401(k) for the purpose of buying a home is a move that should be scrutinized closely to determine if it is the right move for you. A final word of caution: The IRS warns that not only are these funds not guaranteed to come back, but the IRS might also consider this activity as an attempt to avoid or evade paying income taxes. Take this into account and weigh the possible outcomes carefully before taking any action.
“If you have any feedback about can you use your 401k to buy a house that you have tried out or any questions about the ones that I have recommended, please leave your comments below!”
NB: The purpose of this website is to provide a general understanding of personal finance, basic financial concepts, and information. It’s not intended to advise on tax, insurance, investment, or any product and service. Since each of us has our own unique situation, you should have all the appropriate information to understand and make the right decision to fit with your needs and your financial goals. I hope that you will succeed in building your financial future.