If you’ve been saving up money in your 401(k) for years and you want to purchase a home, you might be wondering if you can use your retirement savings to buy your dream home.
Yes, you can use your 401(k) to help fund the purchase of a home, but it’s a strategy that comes with advantages and drawbacks.
Using a 401(k) to buy a house is usually not encouraged. You pay an early withdrawal penalty fee of 10% and pay income tax when you withdraw before retirement age. If you’re under the age of 59½, it might be better to explore other options before using your 401(k) to buy a home.
This guide should help you make the best choice for your situation and help you become an informed home buyer.
What Is a 401(k)?
A 401(k) is an employer-sponsored retirement savings plan company employees can enroll in.
Employees decide how much of their paycheck will be deposited into their 401(k) account every pay period, and employers typically match their contributions. (FYI: The IRS sets annual contribution limits for 401(k) plans.)
Employer benefit matching
One of the really popular benefits of 401(k) plans is the employer match. Depending on a company’s policy, an employer may match a percentage of contributions up to a limit or match contributions dollar for dollar.
Let’s say your gross income is $2,000 per pay period, and you withhold 5% (or $100) from each of your paychecks. If your company matches that percentage or matches dollar for dollar, your employer will deposit an additional 5% (or $100) into your 401(k) account, saving 10% (or $200) every pay period.
Another benefit of 401(k) plans is tax savings. There are two types of 401(k) plans: traditional and Roth.
With a traditional 401(k), your contributions are deducted from your gross income. That means your 401(k) contribution is taken out of your paycheck before income tax is deducted.
As a result, your taxable income is reduced by your total contributions during the year, and your contributions can be reported as a tax deduction. For many people, the deduction can put them in a lower tax bracket and help them get a larger refund from the IRS.
However, during retirement, money withdrawn from a traditional 401(k) account is taxed.
With a Roth 401(k), your contribution is taken from your paycheck after tax. During retirement, you don’t pay tax on the money you withdraw.
You’re allowed to withdraw as much money as you’d like from your 401(k) after age 59½. (FYI: The longer you wait to withdraw money from your retirement account(s), the more it can potentially grow).
If you make a withdrawal before age 59½, you’ll pay penalties and taxes on what you take out. There are, however, some instances when you can withdraw money without incurring a penalty at age 55. And qualified public safety workers can withdraw without penalty starting at age 50.
The penalties have been put in place to discourage you from dipping into your account. You should be using your 401(k) for the sole purpose of planning for retirement.
Should You Use a 401(k) To Buy a House?
Ultimately, it’s up to you to decide. The short answer is yes, you can – but you probably shouldn’t.
And here’s why: Early withdrawal from your 401(k) can have a tremendous impact on your finances over the next 20 – 30 years.
Historically, the average stock market return is around 10% a year (it’s 6% – 7% when you adjust for inflation). Let’s say you had $100,000 in your 401(k), and it was invested in one of your plan’s stock index funds with an annual return of 10%. In 20 years, your $100,000 would balloon to over $730,000.
Now, imagine you withdrew $50,000 from that $100,000 sitting in your 401(k) to make a down payment on a house. In 20 years, you’d have around $360,000 in your 401(k), which is a lot less than $730,000.
The verdict: You got a short-term benefit at a huge long-term cost. In this case, a $370,000 loss.
Before you decide to dip into your retirement account to finance a house, weigh the short-term benefit and long-term impact of that decision on your financial future. Consult with a financial expert to make sure you’re making a decision that doesn’t shortchange your future.
How Do I Use a 401(k) To Buy a Home?
Again, it’s not usually recommended that you use your 401(k) for a home purchase. But if you’ve weighed the pros and cons and you still want to take this route, there are two ways it can be done.
To avoid the 10% early withdrawal penalty fee, use a 401(k) loan. You avoid the penalty, and you don’t pay income tax on the money you withdraw.
Another benefit – and this is big – a 401(k) loan won’t impact your credit score or your debt-to-income (DTI) ratio.
To get a 401(k) loan, you’ll need to meet your employer’s guidelines. And there are other conditions. There is a $50,000 limit on 401(k) loans, and you must pay interest on what you borrow. And, because your 401(k) is connected to your job, losing or leaving your job could affect the loan’s repayment term.
401(k) withdrawal and the CARES Act
Because of federal measures put in place during the COVID-19 pandemic to help people facing financial hardship, money could be withdrawn from eligible retirement accounts – like 401(k) and 403(b) plans and IRAs – penalty-free.
The Coronavirus Aid, Relief, and Economic Security (CARES) Act temporarily suspended the 10% penalty fee for withdrawals up to $100,000. As long as the law is in effect, you can dip into your 401(k) and not worry about paying a penalty fee.
Other Loan Options for Buying a House
You don’t need to withdraw money from your 401(k) to finance a home purchase if you have other types of retirement accounts or qualify for certain loans. Before you take money out of your 401(k), see if these other options might work for you.
Like 401(k) plans, there are two main types of individual retirement plans (IRAs): traditional and Roth. Both of them let you make withdrawals to buy a home as long as you meet specific criteria, including being a first-time home buyer.
A traditional IRA must be at least 2 years old, and the limit for withdrawal is $10,000. You won’t pay a 10% penalty fee, but you’ll pay taxes on the withdrawal.
With a Roth IRA, you can withdraw up to $10,000 without penalties or taxes as long as the account is more than 5 years old.
Federal Housing Administration (FHA) mortgage loans are government-insured mortgages designed to help home buyers overcome credit or savings issues. You can qualify for FHA loans with lower down payments, so you won’t need to dip into your savings as much to finance your home purchase.
One of the downsides of an FHA mortgage is that you pay a mortgage insurance premium (MIP) over the life of the loan. MIP is determined by the size of your loan, the size of your down payment, your loan-to-value (LTV) ratio and the mortgage’s repayment term or length.
All lenders require mortgage insurance for FHA loans, and it’s paid in two parts. First, borrowers pay an upfront MIP that’s 1.75% of their mortgage. The upfront fee can be paid at closing or rolled into the mortgage. Then there is the annual MIP, which ranges from 0.45% – 1.05% of the loan amount. Depending on the mortgage amount, the annual MIP is usually added to your mortgage and divided into 12 monthly payments.
Can you use a 401(k) to help you qualify for an FHA mortgage loan?
Yes, you can use your 401(k) to help you qualify for an FHA loan if you meet the FHA’s mortgage guidelines. But remember, when you withdraw from your 401(k) before retirement you incur fees.
Department of Veterans Affairs (VA) loans are like FHA loans for military service members, veterans and their qualified spouses. They’re backed by the government and come with similar terms, but don’t have a down payment requirement.
Fannie Mae HomeReady® loan
You pay private mortgage insurance (PMI) when you take out one of these loans, but you can reduce or skip premiums over the loan’s term.
Freddie Mac Home Possible® loan
There are options available to reduce your PMI. The size of your down payment can help you get a better interest rate as well.
Programs for first-time home buyers
The federal government and some state governments have programs to help aspiring home buyers become homeowners. If you’re a first-time home buyer, there are resources and programs from the FHA, IRS and your state’s housing department that can help.
Some programs can reduce or eliminate your closing costs, offer tax credits on your loan, qualify you with a lower down payment or offer a better interest rate. Every state has different regulations. Check with your local state agencies to see what kinds of programs you qualify for.
Save Your Retirement Dreams and Consider Alternatives to 401(k) Withdrawal
Before you mortgage your future in pursuit of a home, consider how your actions could impact your finances in years to come.
While you might think you have no other choice but to dip into your 401(k) to buy a home, you might be surprised by the alternatives that can help you without wreaking havoc on your future.
Experian™. “What is the Rule of 55?” Retrieved March 2022 from https://www.experian.com/blogs/ask-experian/what-is-the-rule-of-55/
U.S. Securities and Exchange Commission. “Savings and Investing.” Retrieved February 2022 from https://www.sec.gov/investor/pubs/sec-guide-to-savings-and-investing.pdf
Internal Revenue Service. “Coronavirus-related relief for retirement plans and IRAs questions and answers.” Retrieved February 2022 from https://www.irs.gov/newsroom/coronavirus-related-relief-for-retirement-plans-and-iras-questions-and-answers
Federal Housing Administration. “Mortgage Insurance Premiums.” Retrieved March 2022 from https://www.hud.gov/sites/documents/15-01MLATCH.PDF
Fannie Mae. “HomeReady Mortgage.” Retrieved March 2022 from https://singlefamily.fanniemae.com/originating-underwriting/mortgage-products/homeready-mortgage
Federal Deposit Insurance Corporate. “Home Possible®.” Retrieved March 2022 from https://www.fdic.gov/resources/bankers/affordable-mortgage-lending-center/guide/part-1-docs/freddie-home-possible.pdf