You have been calculating the numbers to figure out how to finance a down payment on a property when it occurs to you that you have a sizable sum of money in your 401(k). Retirement is a long way off, and you could put the money toward a down payment on a property right now. Is it really necessary to use that cash reserve?
A 401(k) is a type of retirement savings plan. These accounts develop in value over time, hopefully leaving you with a substantial sum when it is time to retire. But what if you need that money right away? It is technically doable. However, the costs of early access may outweigh the benefits.
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If you have a 401(k), you are already aware that it is a form of the employer-sponsored retirement savings plan. You contribute a certain amount from each paycheck over time, and your company may even match a portion of your payments to help fund the account.
When it comes to financial goal-setting and retirement planning, your 401(k) account can be a valuable resource. Not only do the funds in this account grow in value over time, but they also come with some important tax benefits: payments to a 401(k) are deducted from your gross income as an employee.
To put it another way, your money can increase without being taxed. Because no taxes have been deducted yet, you can write off the entire amount of your contributions to lower your total taxable income at the end of the year. You do not have to pay taxes on the money you put into a 401(k) or the earnings that accrue until you withdraw the money later in life.
For many people, their 401(k) account is the most important part of their overall savings strategy. If you find yourself in this situation, it may be tempting to invest that money toward a worthy purchase, such as a new home. While taking an early withdrawal and putting money from your 401(k) toward your home purchase is theoretically possible, there are several severe drawbacks to doing so.
Because 401(k)s are meant to be used for retirement, money removed before the age of 59 (or 55 if you leave or lose your work before then) is usually subject to a 10% penalty fee. Yikes. Once you take that money out of your 401(k), they are no longer protected by the account's tax-free shields and are liable to income tax right away. It is similar in cases of self directed IRAs where you can only withdraw $10,000 for making your home’s down payment. The amount is saved from the 10% penalty; however, you still owe income tax on the withdrawn amount.
These fines can be more severe if you have a large sum in your 401(k). You must also evaluate the future wealth losses you may suffer by withdrawing funds from a high-earning account.
If the 10% early withdrawal penalties are not enough to make you think twice, consider the long-term effects of sapping your retirement funds. You will be endangering years of growth by taking that money out, and you will never fully recover. While you can return the money to your account, you will not be able to recover any account earnings that were lost during that period.
Despite the drawbacks, some homebuyers may conclude that the benefits of taking an early 401(k) distribution exceed the risks. You may be eligible for a "hardship withdrawal" if you use funds from your retirement savings to help you buy a home. This means you can get your money without paying a penalty and save the 10% fee (especially if you are buying a home).
While penalty-free access saves you money when you use your accounts, a hardship withdrawal can never be reimbursed into your 401(k)—you would be giving up that money from your retirement savings.
A hardship withdrawal exception must be used for an immediate and severe financial need, according to the IRS. Exemptions for costs directly related to the acquisition of a primary dwelling (excluding mortgage payments) are sometimes available.
You can only withdraw the amount needed to meet an emergency need, and if you have any additional assets that could theoretically be used as a down payment, you are unlikely to be granted a hardship exception. Even if your withdrawal qualifies for exemption, the whole amount withdrawn will be subject to income tax.
Withdrawing 401(k) funds for a down payment is not the only option. 401(k) loans may be available through your benefits provider. This option, if available, allows you to avoid not only the early withdrawal penalty cost but also paying income tax on your withdrawal.
You can borrow up to 50% of your vested account balance (up to $50,000) with a 401(k) loan. When you take out a loan like this, your 401(k) account is put on hold for the period of the loan, and you will not be able to make any additional contributions until the loan is paid off.
But how can you know if taking out a 401(k) loan is a good investment? As with every lending situation, the cost of borrowing money has a significant impact on whether or not the loan is worthwhile. For these types of loans, you should expect a 1% to 2% rate increase above the prime rate. Another thing to think about is your work situation. If you do not pay back the loan on time or before leaving/losing your work, you could face the same financial consequences as if you had taken the loan out.
For some borrowers, coming up with the funds to make a down payment on a home can be difficult. While utilizing money from your 401(k) to pay for the down payment on a home is legally possible, it is not necessarily the wisest decision.
You might wish to look at other loan choices with more flexible down payment possibilities before commencing the withdrawal procedure. Some mortgage programs allow you to put down as little as 3% of the buying price on a home.
If you are sure you are ready to buy a house, find out what rates you qualify for and get pre-approved to learn more about your possibilities. You may get pre-approved in as little as three minutes with Better Mortgage.
If you are interested in more articles like this, check out this article on how to write a strong lease agreement.
