Get All Access for $5/mo

Pros and Cons of Using Your 401K to Buy a House Saving for a down payment on a house is often not an easy task. A down payment can be a substantial amount of money, depending on the price of the...

By Carolyn Young

This story originally appeared on Due

Saving for a down payment on a house is often not an easy task. A down payment can be a substantial amount of money, depending on the price of the house, and a weekly or monthly savings plan can take years to add up to enough.

There are ways to use your 401K to buy a house, but doing so has implications you need to consider.

Here we'll discuss the pros and cons of using your 401K to buy a house so that you can make an informed decision.

Pros of Using Your 401(k) for a House Purchase

Down Payment Assistance

If you've been contributing to your 401K for a while, using 401(k) funds can provide a substantial down payment, potentially leading to better mortgage terms and interest rates. Generally, the more you put down, the less risk the investor has, so they're apt to give you more favorable loan terms.

Putting more money down also gives you immediate equity in the house, which can allow you to take out a home equity loan at some point for things like home improvements.

Avoiding Private Mortgage Insurance

If you put down less than 20% on your new house, you'll generally have to purchase private mortgage insurance, which is not cheap. Private mortgage insurance protects the lender from your potential default and may have to be paid monthly, as an upfront fee, or both.

If you use 401K funds to make a 20% or more down payment, you can avoid private mortgage insurance.

Competitive Offers

In today's real estate market, home inventory is quite low, which means that often multiple buyers are competing for a home. A higher down payment makes you a more attractive buyer since your mortgage loan is more likely to be approved. This could be a deciding factor in a home seller choosing to accept your offer over others.

Flexibility in Repayment

You have a few options to access your 401K funds, the most preferable being a 401K loan. If you take a 401K loan, you'll have flexible repayment terms and you'll be making payments essentially to yourself. Generally, the rule is that you must make at least quarterly payments, which can be made with payroll deductions, and pay the loan back within five years.

Cons of Using Your 401(k) for a House Purchase

Impact on Retirement Saving

Perhaps the most important thing to consider is the effect of a 401K withdrawal on your retirement savings. There is a huge retirement savings gap in the United States, with 55% of people saying that they are behind on saving for retirement and more than 25% of people with no retirement savings at all.

This leaves many people with no option but to work during their retirement years to supplement their Social Security.

You need to give it serious consideration before you take that risk instead of waiting until you can save other funds to purchase a house.

Tax Implications

Withdrawing funds from your 401K before the age of 59 1/2 comes with significant tax consequences. You'll be responsible for paying income tax on the withdrawn funds for the year of the withdrawal. You'll also incur a 10% IRS penalty that year.

That means that if you withdraw $25,000 and you're in a 22% tax bracket, you'll pay $5,500 in income taxes and a $2,500 penalty, leaving you with only $17,000 from the withdrawal.

Opportunity Cost

Since 401K funds are in investment vehicles, you'll lose the potential for investment gains that could accumulate over time if the funds remain in the 401(k). Right now, your 401K funds are working for you making money, but if you withdraw the funds, you'll lose that source of financial returns.

Market Timing Risk

Investments in a 401K can fluctuate with the market in the short term, so if you withdraw funds during a market downturn, you could lose some of the funds you've invested. 401K investments are intended to bring long-term returns because markets naturally have ups and downs in the short term.

Ways to Access Your 401(k) for a House Purchase

Your optimal choice is securing a 401(k) loan. This route allows you to access the necessary funds while subsequently making repayments back into your account. Essentially, you're repaying yourself. As long as you adhere to the repayment terms specified by your plan, you can sidestep tax consequences and avoid disrupting your long-term financial plan.

Typically, you have the ability to borrow up to 50% of your vested account balance, or a maximum of $50,000—whichever is less. However, if half of your vested balance is lower than $10,000, you can borrow up to the $10,000 mark.

In general, the rules dictate that you must make at least quarterly payments and repay the loan within a five-year period.

Another avenue is pursuing a hardship withdrawal, which comes into play when your plan sponsor (your employer) determines that you have "immediate and heavy financial need." It's important that your plan allows for such withdrawals and specifies criteria for them. Generally, the purchase of a home will qualify for a hardship withdrawal.

The IRS establishes criteria to deem a distribution necessary:

  • The distribution doesn't surpass the amount of the immediate and heavy financial need, which includes the necessary amounts to cover resulting taxes.
  • The employee has exhausted all other available distributions (excluding hardship distributions) and non-taxable (at the time of the loan) plan loans, encompassing all other plans the employer maintains.
  • The employee is prohibited from making elective deferrals to the plan for a minimum of six months after the hardship distribution.

Additionally, your employer must determine that your immediate financial need cannot be fulfilled using alternative resources. Often, a written statement from you will suffice.

Keep in mind that hardship distributions are subject to income taxes and may still incur the 10% penalty, making a 401K loan a more desirable alternative.

Be sure to talk to your plan administrator about the options for withdrawal that your plan allows.

Considerations Before Using Your 401(k) for a House Purchase

First of all, if you decide to take a 401K loan, you'll need to understand the allowable terms on the loan specified by your plan.

It will involve making payments including interest on the loan from payroll deductions, which may impact your ability to qualify for your mortgage loan. The lender may include your 401K loan payments in your debt-to-income ratio, which could reduce the amount of the mortgage loan that you'll qualify for.

Second, assess how using your 401K will affect your long-term retirement plan. If don't have a plan, you should create one to see how it may be impacted by your home purchase with 401K funds. As discussed earlier, many people lack sufficient retirement funds, and you don't want to put yourself in that category.

Third, look at any potential alternative funding sources for your home down payments. Options such as liquidating other assets, downpayment assistance programs, or even gifts from family may be better choices. You may also want to consider buying a less expensive house than you had in mind.

Finally, evaluate your personal financial stability and job security before using retirement funds for a home purchase. If you haven't been able to save for a down payment, you may not be in a good position to buy and maintain a house. You may be better off putting together a plan to save specifically for a home down payment before you use your retirement nest egg.

It's highly advisable to discuss your financial situation and your potential house purchase with your financial advisor before taking any action. They can help you assess your financial and retirement goals, explore options, and create a full long-term plan for you to meet your goals. They have tools that they can use to create a plan based on your specific needs, time to retirement, and risk tolerance.

Continue Your Retirement Savings Plan

If you make the choice to use your 401K for your home purchase, be sure to get right back on the horse and continue making contributions to your retirement account and other retirement and investment accounts. Even small contributions will grow over time and earn a return.

Too often, people fail to look ahead and focus only on their short-term goals – like buying a house. Then later in life, they're not able to live the lifestyle they want or have financial security. When you reach retirement age, you deserve to have the freedom to enjoy life and do things that are important to you.

Conclusion

Using a 401K to purchase a home is a big step that can come with serious financial consequences. Look at all of the alternatives and consider all factors. Your mortgage lender and your financial advisor can be great resources for finding alternatives and weighing the pros and cons of each.

The post Pros and Cons of Using Your 401K to Buy a House appeared first on Due.

Want to be an Entrepreneur Leadership Network contributor? Apply now to join.

Editor's Pick

Growing a Business

He Immigrated to the U.S. and Got a Job at McDonald's — Then His Aversion to Being 'Too Comfortable' Led to a Fast-Growing Company That's Hard to Miss

Voyo Popovic launched his moving and storage company in 2018 — and he's been innovating in the industry ever since.

Branding

ChatGPT is Becoming More Human-Like. Here's How The Tool is Getting Smarter at Replicating Your Voice, Brand and Personality.

AI can be instrumental in building your brand and boosting awareness, but the right approach is critical. A custom GPT delivers tailored collateral based on your ethos, personality and unique positioning factors.

Business Ideas

63 Small Business Ideas to Start in 2024

We put together a list of the best, most profitable small business ideas for entrepreneurs to pursue in 2024.

Business News

Is the AI Industry Consolidating? Hugging Face CEO Says More AI Entrepreneurs Are Looking to Be Acquired

Clément Delangue, the CEO of Hugging Face, a $4.5 billion startup, says he gets at least 10 acquisition requests a week and it's "increased quite a lot."

Business News

You Can Now Apply to Renew Your U.S. Passport Online — But There's a Catch

The U.S. State Department officially launched the beta program this week.

Business News

Sony Pictures Entertainment Purchases Struggling, Cult-Favorite Movie Theater Chain

Alamo Drafthouse originally emerged from bankruptcy in June 2021.