Can I Use My 401(k) To Buy A House?
Victoria Araj7-minute read
November 18, 2020
For many would-be homeowners, the down payment is the biggest entry barrier to buying a house. While down payments can be as low as 3.5%, 20% is ideal if you want to secure a mortgage without monthly mortgage insurance fees.
If you’re having trouble gathering funds for a down payment, you might find yourself considering using your 401(k) retirement fund as a convenient source of cash. While this is technically allowed, and could help you cover your down payment, there are some factors and drawbacks that you might want to consider.
We’ll break down the pros and cons of making a 401(k) withdrawal for a home purchase, as well as some alternatives.
A 401(k) Refresher
Before diving into whether you should use your 401(k) to buy a house, it’s important to first have a firm grasp on how, exactly, a 401(k) retirement account works.
Your 401(k) account is an earmarked savings account created specifically to help you prepare for retirement. As defined by the Internal Revenue Code of the IRS, 401(k) holders can claim a tax deduction and will see their contributions to the account accrue tax-free interest over time. The trade-off is that access to the account is strictly limited.
Withdrawals from a 401(k) should not be made before the account holder turns 59½, or before they turn 55 and have left or lost their job. Early withdrawals incur a 10% early withdrawal penalty on the amount of money being taken out of the account. This amount also immediately becomes subject to income tax, since it’s no longer in the protected retirement savings account.
While these regulations may seem harsh, they are in place to incentivize account holders to set aside enough money to support a comfortable retirement. That being said, it’s not illegal to withdraw money from your 401(k) early, and those funds can certainly be put toward a down payment on a house. But the question remains: Is it a smart move?
Should You Use Your 401(k) To Buy A House?
There are good reasons for not using your 401(k) to buy a house. Even if you’re comfortable with the 10% early withdrawal penalty, you will still be incurring long-term consequences by reducing your savings. That, in turn, will damage your future growth potential.
Taking out $10,000 from a $20,000 401(k) account, for instance, leaves you with only $10,000 that will continue accruing interest. With a 7% annualized rate of return, that $10,000 could become $54,000 over 25 years – compared to $108,000 had you not withdrawn $10,000.
Withdrawing from your 401(k) account is essentially taking out a loan against yourself. If you want to pay it back, you also need to pay interest, and the time spent paying it back is time that could have been spent on growth.
2 Ways To Use Your 401(k) To Buy A House
If you do decide to use your 401(k) to buy a home, there are two options available.
1. Obtain A 401(k) Loan
The first option is to obtain a 401(k) loan. This is the better of the two options: not only do you avoid the 10% early withdrawal penalty, but the amount you withdraw will not be subject to income tax.
There are other benefits to a 401(k) loan, as well. It doesn’t count toward your debt-to-income ratio, and it won’t be counted by credit bureaus. So, taking a 401(k) loan won’t hurt your credit score and won’t affect your odds of qualifying for a mortgage.
The maximum amount allowed to be withdrawn in a 401(k) loan is $50,000. It must be paid back with interest, typically between 1% – 2%, and you won’t be able to make additional contributions to your 401(k) account until the loan amount has been repaid. That means your employer won’t be matching any contributions, either. Taking out a loan essentially puts a freeze on your 401(k) until it’s been paid in full. Depending on how long that takes, you could miss out on years of growth.
Not all employers offer 401(k) loans as an option in their retirement plans, though. It’s also important to note that you are still required to repay the loan even if you leave your current job or are laid off. In fact, your repayment period shortens once that happens, and the loan must be repaid in full by the next tax filing date.
If you can’t make this due date, then the loan amount becomes a 401(k) withdrawal in the eyes of the IRS. That means you’ll be subject to income tax and will be required to pay the 10% early withdrawal penalty. So, before taking out a 401(k) loan, make sure your career is stable.
2. Make A 401(k) Withdrawal
Your second option would be to make a direct withdrawal from your 401(k) account. As mentioned above, this is the less desirable of the two options.
An early withdrawal would be classified as a hardship withdrawal. The IRS considers any emergency removal of funds from a 401(k) to cover “an immediate and heavy financial need” as a hardship withdrawal. Whether or not the purchase of a home using your 401(k) counts as a hardship withdrawal is a determination that falls to your employer, and you will need to present evidence of hardship before the withdrawal can be approved.
Regardless, you will still likely incur the 10% early withdrawal penalty. There are exemptions in place for specific circumstances, including home buying expenses for a principal residence. Qualifying for such exemptions is difficult by design, however. If you possess other assets that could be used for your home purchase, then you likely won’t qualify for an exemption. Even if you do, your withdrawal will still be taxed as income.
A Note About The CARES Act
Signed into law on March 27, 2020, the $2 trillion dollar Coronavirus Aid, Relief and Economic Security Act (CARES) emergency stimulus bill was drafted to help those affected by the coronavirus pandemic. Under the act, 401(k) account owners can make a hardship withdrawal of up to $100,000 without paying the 10% penalty. The bill also grants the account holder 3 years to pay the income tax, rather than it being due within that same year.
Alternatives To Using Your 401(k)
Even if you’re short on cash and facing hardship, there are other options you might want to consider before tapping into your 401(k) account to cover the down payment on a house.
If you have an IRA, you should look there for extra funds before considering an early withdrawal from your 401(k). IRAs are built with special provisions for first-time home buyers, which the IRS defines as anyone who hasn’t owned a primary residence within the previous 2 years.
Under these provisions, first-time home buyers are allowed to withdraw up to $10,000 without incurring the 10% penalty. However, that $10,000 is still subject to state and federal income taxes. If your withdrawal exceeds $10,000, then the 10% penalty is applied to the additional distribution.
A Roth IRA is an even better option, if you have one. Some plans allow you to make a hardship withdrawal, and up to $10,000 can be withdrawn tax-free for the express purpose of a first-time home purchase.
An FHA loan is a government-backed mortgage with looser requirements designed to make it easier for first-time home buyers to purchase a property. This includes low down-payment options and lower credit score requirements. For this reason, an FHA may be a better option than making a withdrawal from your 401(k).
FHA loans require a minimum down payment of 3.5%, but only if your credit score is 580 or higher. If your score is between 500 – 579, then the minimum down payment is 10%. Rocket Mortgage®’s minimum credit score requirement for an FHA loan is 580.
There are a couple caveats to consider for an FHA loan. First, you need to qualify for one. This process involves your prospective home being reviewed by an FHA-approved appraiser. The home must also be your primary residence and you must occupy it within 60 days of closing the purchase.
Additionally, FHA loans require the borrower to have mortgage insurance for the life of the loan, or for 11 years if you made at least a 10% down payment. FHA loan mortgage insurance includes a 1.75% upfront premium charge and an annual premium – anywhere from 0.45% to 1.05% – based on four factors:
- Mortgage term
- Loan-to-value ratio
- Total mortgage amount
- Size of your down payment
If you are an eligible service member, a veteran or the spouse of one, then a VA loan could be a better alternative to withdrawing from your 401(k) account.
Like an FHA, a VA loan is government-backed and includes lower interest rates and more flexible terms. The one major difference is that a VA loan requires no down payment. In order to qualify for a VA loan, you must satisfy at least one of these criteria:
- Served more than 6 years with the National Guard or Reserves
- Served 90 consecutive days of active service during wartime
- Served 181 days of active service during peacetime
- Are the spouse of a service member who lost their life, either in the line of duty or as the result of an injury gained during their active service
If you meet one of these requirements, you can obtain a Certificate of Eligibility for a VA loan by demonstrating proof of service as a veteran, active member or spouse. The type of proof required varies depending on which category you fall into.
Find The Mortgage Option That’s Right For You
Your 401(k) account may seem tempting as an untapped source of cash, especially if you’re struggling to come up with the money for a down payment on your new home. While this is a viable option, and there are ways to mitigate the penalties, it should only be used as a last resort. Consider applying for a low down-payment loan like an FHA or VA loan, or, if you have one, making a withdrawal from your IRA.
Whatever you decide, make sure you consult with a mortgage specialist before committing to an option. Rocket Mortgage® has experts waiting to help you navigate the tricky waters of home loans. If you’re ready to take that next step toward a mortgage, then get started with our experts today.
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