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If you’re planning to buy a property, but are pressed for funds, you can either apply for a loan or use your 401k to purchase the house. If you’re wondering, if can I use my 401k to buy a house without paying any taxes or a penalty, keep reading.
Keep in mind that a 401(k) loan is not just limited to first-time homebuying; you can also utilize the funds for a second home, building a house, or home improvements. However, there are certain downsides to 401k withdrawals – all of which we’ll discuss below.
What is a 401(k) loan?
A 401k loan is when you get funds against your retirement savings. However, your 401(k) plan provider or an administrator will decide on the interest rate and the other repayment terms. The maximum loan term for this loan type is generally five years. However, if the loan is for a principal residence, you may be able to get a longer term.
Keep in mind that your loan payments don’t count as contributions to your retirement plan account. And hence, these do not get you a tax break.
What are the rules for a 401(k) loan?
Every employer’s plan may have different rules for 401(k) withdrawals and loans. A traditional 401(k) lets you deduct your contributions from your taxable income and lowers the tax bill for the financial year. Then, when you make withdrawals in retirement, you pay taxes. And if you take out the money early, you may incur a 10% early withdrawal penalty and also owe income tax on the withdrawal amount. The only way to avoid penalties is if you happen to be in any of the following situations. These are termed hardship withdrawals.
- Your medical debt exceeds a set percentage of your adjusted gross income.
- The account holder has suffered permanent disability or has died.
- You’re on active duty.
- A court has ordered a withdrawal in order to pay a former spouse or a dependent.
- You need to pay a down payment for a primary residence.
- You owe money to the Internal Revenue Service (IRS).
Even with an exemption, you’ll still owe income taxes on the withdrawal amount. If you’re fine with penalties and taxation, you can make outright withdrawals and the withdrawn funds do not have to be repaid. You can then replenish the 401(k) account with new contributions from your paycheck.
How much money can you take out of your 401(k) to buy a house?
You may withdraw as much as 50% from your retirement savings account within a 12-month period, up to a maximum amount of $50,000 – depending on what your employer’s plan permits.
Generally, you have the option to borrow
- $10,000 or half your account balance
Remember that you’ll incur interest and cannot make contributions until the loan is repaid.
How much can you utilize your individual retirement account to buy a house?
First-time homebuyers or those who’ve not had homeownership for at least two years are allowed to withdraw $10,000 from their individual retirement account (IRA). And, there’s usually no penalty. They can utilize the funds to buy a home, renovate, or rebuild it.
Can I use my 401(k) to buy a second house?
If you’re prepared to incur an early withdrawal penalty of 10% and taxes, you can withdraw money from 401(k). However, unlike in the case of first-time home buyers, those using the funds to buy a second home will face the penalty and taxation in all situations.
What’s the downside of using a 401(k) loan to buy a property?
Tapping your retirement account early, for whatever reason, has certain drawbacks. Not only do you end up diminishing your retirement savings, but you also lose out on a potential increase in funds if that money is not invested properly. Suppose you had $20,000 in your retirement savings account and you took out a loan of $10,000 to buy a house. You’ll lose out on the increase in your investment. The $10,000 you withdrew could have grown to $54,274, with a 7% annualized return, in the next 25 years. And, if you let the $20,000 be in your account, it could grow to $108,548 in 25 years. That’s some good money-making opportunity lost!
What are the alternatives to using 401(k)?
Borrowing from your 401 k early to buy real estate is not a good idea. Before you do, it’s best to consider all your loan options and then make an informed decision. You may also consider using funds from your IRA. If you borrow up to $10,000 for a first-time home purchase, before the age of 59½, you’ll not incur any penalty.
The best solution would still be to delay your homebuying plan until you have enough cash or have a loan that lets you borrow money on good terms. We understand that delaying homebuying may also mean higher home prices and interest rates for you. You may take your financial situation into account and take a calculated risk.
Another option you may consider is taking advantage of homeownership programs by the federal government. These could include those offered by the Federal Housing Administration (FHA loans), the U.S. Department of Veterans Affairs (VA loans), and the U.S. Department of Agriculture (USDA loans). Such loan programs offer lower down payments and do not have stringent credit score requirements.
If you must use your 401(k) funds, it should be for an immediate cash need – maybe for a down payment, closing costs, a medical emergency, or an escrow account. After all, it’s not a pleasant experience to see your total retirement account balance drop.
Having said that, the best strategy to come up with funds to buy a house will depend on your personal financial situation. It’s a good idea to consult with a financial advisor for guidance. If you do opt for a 401(k) withdrawal, remember to take steps to keep your retirement savings on track. And, be prepared to face a penalty and taxes – unless it’s a hardship withdrawal. So now you know the answer to, can I use my 401k to buy a house? You can. But, should you? You decide.