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

Table of content

The Basics On Using 401k to Buy a Home

Frequently Asked Questions (FAQs)

What is a 401k loan?

What is a 401k withdrawal?

How to use 401k to buy a house?

Can you use 401k to buy a second home?

Can you withdraw money from 401k to buy a home?

How to borrow from your 401k to buy a home?

Can you use your 401k to pay off your house without penalty?

Does 401k count as income when buying a house?

Can you use 401k for closing costs?

Can you gift 401k to buy a house?

Do lenders look at 401K?

How much of my 401k can I borrow to buy a house?

You must have seen that taking a loan from a 401k plan is robbing your retirement. Guess what – a 401k loan can be appropriate in some situations if used correctly. If you need cash for a down payment, and you happen to have a retirement plan at your current job, you might be wondering if you can use it to become a first home buyer. The short answer is yes, you are allowed to use funds from your 401k plan to buy a home. However, there is an opportunity cost in doing so; the funds you take from your retirement account cannot be made up easily and you’ll need to speak with your employer first.

The Basics On Using 401k to Buy a Home

A 401k loan is a preferred method if you think about using 401k to buy a house. That’s because there’s a much lower cost associated with using 401k for down payment loan compared to withdrawing from 401k. If you decide to borrow the money, you’ll be asked to repay the loan within five years with interest, which is generally at the interest rate of 2 points over a “prime rate.” Nevertheless, the interest will be practically used to pay yourself, which makes it far less tedious. Only keep in mind that loans are paid with after-tax dollars! What does it mean? If you consider taking money out of 401k for house, you will be missing out on the tax benefits that make 401k accounts attractive in the first place.

In addition to that, if you use a 401k for a down payment right before you leave your job, the total amount must be repaid before you file taxes for the year in which you decided to quit your job. If you don’t honor the given deadline, its operation will be considered a withdrawal, and the amount –now withdrawn- will be taxed at ordinary income tax rates.

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There are other pros to a 401k loan:

• It doesn’t count toward the debt-to-income ratio, and credit bureaus won’t take it into consideration against you.
• Taking a 401k loan won’t hurt the credit score or affect the odds of qualifying for a mortgage.

The maximum amount allowed to be withdrawn in a 401k loan is 50,000$ and here are some further stipulations:

• It must be paid back with interest, typically between 1% and 2%.
• Additional contributions to your 401k account aren’t possible until the loan amount has been repaid, which means your employer won’t match any contributions.
• Taking a 401k loan basically puts your 401k on hold until it’s been paid in full! Depending on how long that takes, years of growth could be missed.

Not all employers offer 401k loans as an option in their retirement plans, and it is crucial to keep in mind that you are still required to repay the loan even if you leave your current job. In fact, once it happens, your repayment period shortens, and the loan must be repaid, in full, by the next tax filing date.

The rules for taking a loan from 401k to buy house are as follows:

• Your employer must allow 401k loans as part of its retirement plan.
• The loan must be paid back with interest (typically the prime rate plus 1% or 2%) on a schedule agreed upon by yourself and your 401k provider.
• Naturally, you cannot make 401k contributions while you have an outstanding 401k loan.

If you can’t repay the 401k loan by this due date, the loan amount becomes a 401k withdrawal in the eyes of the IRS. Meaning? You’ll be subject to income tax while being required to pay the 10% early withdrawal penalty. So, make sure your career is relatively stable before taking out a 401k loan. 

Remember that:

• A 401k loan is usually not counted in your debt-to-income ratio, so it won’t negatively affect your chances of mortgage qualifying.
• 401k loans are not reported to credit bureaus, so applying for one won’t damage and downgrade your credit score.

Frequently Asked Questions (FAQs)

What is a 401k loan?

A 401k loan is when you take a loan from your own 401k, which is defined by The Internal Revenue Code of the IRS as earmarked to save for retirement. Like a typical loan, you will be borrowing money from yourself. While 401k account holders can claim tax breaks and deductions and be able to see their contributions to the account over time, 401k loans are paid in addition to origination fees and interest. You must be familiar with 401k loan rules because not all plan providers allow them. If they don’t, you will need to go with a 401k withdrawal from the account.

What is a 401k withdrawal?

A 401k withdrawal is an act of withdrawing money from the 401k to buy a first home, for example, up to the account balance limit. You’re only allowed to withdraw from 401k for house as much money as you need to meet your financial needs, without the obligation to pay it back. You can, of course, begin paying back to your 401k account with new contributions taken from each paycheck.

How to use 401k to buy a house?

If you don’t have the entire amount or you’re short on cash for a down payment, you might be wondering if you can use 401k to buy house if your dream home comes on the market. The answer to your question is yes, you’re allowed to use funds from your 401k for a home purchase.

However, there is an opportunity cost in doing so; the funds you take from your 401K retirement account cannot be replenished as quickly as you may imagine. You can start thinking about using retirement funds to buy a house, either by taking a loan or withdrawing money from the account. Keep in mind that not all providers allow the option of a 401k loan for down payment. If they don’t allow a 401k loan or if you need more than what is allowed, you will be obligated to go with an outright 401k withdrawal for a home purchase.

Can you use 401k to buy a second home?

Good news – you can use your 401k to buy a second home. You can, in fact, withdraw from 401k for home and use the amount to purchase a second home or vacation retreat. While you could be hit with a 10% tax penalty, several exceptions are possible for you to sidestep this massive downside. You should note that withdrawals aren’t state-specific when it comes to penalties, your state income tax may be affected.

Can you withdraw money from 401k to buy a home?

While 401k withdrawal to buy a first home is possible, they are generally not recommended due to steep fees and penalties that aren’t applied to 401k loans. In reality, you will be making what’s known as a hardship withdrawal. This is considered by what the IRS sees as any emergency removal of funds from a 401k to cover “an immediate and heavy financial need.” Whether or not purchasing a home using your 401k counts as hardship withdrawal is a tricky question. It’s a determination that falls to your employer, and you will need to justify this hardship before the withdrawal can be permitted.

How to borrow from your 401k to buy a home?

In general, the IRS allows you to borrow from your 401k to buy a home if the money is urgently needed. To start the process, you’ll need to speak with your employer to get their go-ahead.

In terms of numbers, remember that if you decide to take the first time home buyer 401k withdrawal 2021 before age 59 (and six months), you will be requested to pay:

• What is called a 10% “early withdrawal” penalty on the funds removed from the 401k
• Income tax on the amount withdrawn

There are exemptions in place for specific circumstances, including a 401k first-time homebuyer. Qualifying for such exemptions is difficult by design. However, if you possess other financial resources or assets eligible to be used for your 401K home purchase, you probably won’t be able to qualify for an exemption. Even if you manage to do so, your withdrawal will still be taxed as income.

Can you use your 401k to pay off your house without penalty?

There is a significant cost when it comes to using 401k to buy first home before you hit your 6-month mark to your 60th birthday to pay off a house. The IRS imposes an early withdrawal penalty of 10% from these qualified retirement accounts. So unless it’s your last resort, it’s highly inadvisable. Account-holders will also owe regular income tax on the amount, like any distribution from the account at any age. Even then, there are always other alternatives, such as hardship withdrawal provisions that can protect from tax penalties if they have certain conditions and are then simply taxed as regular income. Keep in mind that:

• If your cashed 401k loan is not repaid by its due date, the remaining balance is treated as a 401k withdrawal, meaning it will be taxed as income and subject to a 10% penalty.
• Unlike withdrawing from 401k to buy a house, a 401k loan is not subject to a 10% early withdrawal penalty from the IRS.

Does 401k count as income when buying a house?

It can count as income when you decide to use 401k for home purchase:

• Withdrawals from your 401k count as income, so you’ll need to pay tax on any amount you withdraw.
• Additionally, using your 401k to buy a first home if you are younger than 59½ will cause paying a 10% early withdrawal penalty on top of your regular income tax.
• Unlike a 401k withdrawal, money received from a 401k loan won’t be taxed as income.

Can you use 401k for closing costs?

Lately, home buyers have begun turning to their 401k retirement accounts for the additional amounts they need to cover the closing costs. However, if you consider this option, you may face penalties from the IRS if you find yourself unable to pay back the loan due to the termination of your current employment.

Can you gift 401k to buy a house?

Gifted funds can be used to make a home down payment, but your refinance mortgage lender will need to know some details before allowing you to use it. Only two specific groups are allowed to give first-time home buyers money to fund their down payment.

• Government agency: as part of a program dedicated to allowing first-time buyers into the market
  
• A family member or a friend: As long as the standing relationship with the home buyer can be proven. The gift letter used for this purpose and signed by both interested parties must explicitly state that the money is a gift, with no expectation of repayment. In many cases, there is absolutely no limit on the amount of gift money destined to go into a down payment, as long as the individual is a first-time home buyer aiming for a primary residence. However, if you decide to use the gifted down payment to buy a second home or an investment property, you will have to pay at least 5% of the down payment, while the rest can be a gift.

Do lenders look at 401K?

Despite the fact that if you withdraw 401k for house loan is a new monthly obligation, lenders don’t count that obligation against you when analyzing your financial statements and debt-to-income ratio because the payment is not seen the same way as another regular loan. This is just like a car payment or student loan payment! Therefore, if your debt-to-income ratio is already high, you don’t need to worry that your 401k home down payment will push you over the edge, nor will it downgrade your credit score.

However, the lender will deduct the available balance of your 401k loan by the amount of money you borrowed. Therefore, you might need to think twice before borrowing from your retirement savings if you are short on cash reserves. Some loan types require two months of housing payment reserves after closing.

How much of my 401k can I borrow to buy a house?

In general, you can only borrow from 401k to buy home up to 50%, or $50,000, whichever is less. Some plans may even offer an exception if your balance is less than $10,000, allowing you to withdraw the entire amount. On the other hand, withdrawing from 401k for house is unlimited, assuming your plan will enable you to do so. Your first step should be to contact your employer before making any offers on a home, assuming you can take from your 401K.

You want to keep more of your money than spend it – at least most people do! That’s why Richr gives 2% back to home buyers, so they don’t have to risk their 401K or quickly replenish it with the funds received. Building wealth for tomorrow starts with the choices you make today.