Mortgages

Can I Use My 401k To Buy A House Without Penalty

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 6 minute read

Saving for a home’s down payment can be a major time commitment, but it can pay off in the long run when you buy a home.

Having funds in retirement accounts, though, may allow you to cut down the time involved. We’ll go through ways to minimize your tax and penalty obligations when purchasing your first home, as well as the types of accounts from which you may withdraw money without incurring fees.

Using Your IRA to Make a Down Payment on a House

The IRS imposes a 10% penalty on early withdrawals from retirement funds if they are made by someone younger than 59 1/2.

Roth IRA

Withdrawing funds from a Roth IRA will incur the fewest taxes and penalties of any retirement plan kind. This is due to the fact that there are no time restrictions on withdrawals and no taxes or penalties for doing so.

In addition, after five years of account ownership, you can take out up to $10,000 in profits tax-free and penalty-free to use toward your first home’s acquisition, repair, or renovation. 

That is to say, even if you take out all of your contributions, you can still take out an additional $10,000 without incurring the 10% penalty or any additional tax liability.

However, there is a catch: you only have 120 days to spend the money you withdraw or you may be subject to a penalty. In addition, the financial services company you use to manage your Roth IRA will automatically take off all of your contributions before any earnings.

Traditional IRA

Next best is a typical Individual Retirement Account. Withdrawing up to $10,000 for a first-time home purchase, repair, or renovation remains a penalty-free option; however, you will be responsible for paying full income tax on the whole amount. Those who have a SEP IRA or a SIMPLE IRA are subject to the same regulations.

Money withdrawn from a conventional IRA must be used to buy a property within 120 days or a 10% penalty will be assessed. Alternatively, if you want to help a family member buy a home, you can take up to $10,000 out of your IRA without incurring any penalties.

If you and your spouse are married, you may both withdraw $10,000 from your respective conventional IRAs tax-free to spend toward a down payment, just as you would with a Roth IRA. Each person has a lifetime cap of $10,000.

Making a Down Payment with Your 401k

Withdrawals from a 401(k) are subject to penalties unless they are used for a “hardship exemption,” but there is no explicit exception for house purchases. It’s important to note that in addition to paying income tax on the withdrawn amount, you’ll also be subject to a 10% early withdrawal penalty.

To avoid the 10% early withdrawal penalty, you should transfer the funds to an IRA if at all possible. A 401(k) plan that you have with an employer for whom you are still employed cannot be rolled over. Roll over your prior 401(k) from your previous employment if you have one. It’s best to have the paperwork for the rollover started as soon as feasible.

Using Your 401k to Borrow

Taking out a loan against your 401(k) is another choice. You may borrow up to 50% of the account’s value, or $50,000, whichever is less. This is typically a cheaper choice than a simple withdrawal, but only if you can afford the payments (yes, you do have to pay back this loan).

You will have to pay interest on the loan amount, but there will be no additional fees or fines imposed. Here are some key points about 401(k) loans:

  • You may find it harder to qualify for a mortgage if you take on debt and have to make regular payments.
  • Typically, the interest rate on a 401(k) loan is two percentage points more than the prime rate. However, the interest you pay won’t be used to pay off the loan; instead, it will be contributed to your 401(k) plan.
  • A common repayment period for loans is five years. This means that if you borrow a significant sum, the repayments may also be considerable.
  • Depending on the company’s policy, you may be compelled to repay the unpaid sum within 60–90 days after leaving employment or accept it as a hardship withdrawal.
  • The amount you still owe will be subject to taxes and penalties.
  • With payroll deduction, only the interest portion of your payment will be subject to taxation. Interest payments will be twice taxed if you begin taking withdrawals in retirement.

If you’re receiving an FHA loan and just require a tiny down payment, a loan against your 401(k) may be a good option to meet the cost of the down payment. However, if you have a huge loan payment, this might significantly affect your ability to get a mortgage.

Take into account that the monthly payment (at 6% interest) on a 401(k) loan of $5,000 will be $93, while the monthly payment (at 6% interest) on a loan of $25,000 would be $483. Banks will assess your capacity to make the latter payment when determining your loan amount.

In light of this, it’s important to do the math and consult with a mortgage broker to find out how taking out such a loan can influence your eligibility. On the other hand, it may make sense to withdraw the down payment amount and pay the taxes and penalties if the amount you require will have too negative of an effect on your qualifying.

Mortgage Interest Tax Planning

After buying a property, you can deduct the mortgage interest you pay from your taxable income. This might “wash” with all or part of the retirement account withdrawal income you’ve reported.

Imagine you have a $25,000 mortgage interest payment and a $25,000 401(k) withdrawal in the same year. You can deduct the same amount from your taxes as you would report in increased income (from the 401k withdrawal). Basically, the withdrawal won’t affect your taxable income at all, so you won’t have to worry about paying any taxes on it.

However, the 10% penalty, or $2,500 in this situation, will still be your responsibility. If you remove more than $10,000 from your IRA, SIMPLE, or SEP, you will be subject to the 10% early withdrawal penalty.

Comparison of Retirement Account Withdrawals

That being said, which is ideal? The answer to this question is contingent on the kind of accounts you maintain and the amounts you have placed thereon. When saving for a down payment, it’s best to tap into a Roth IRA rather than a standard IRA, and either of those accounts rather than a 401(k), in terms of the taxes and penalties you’ll have to pay.

The size of the loan and how it could influence your eligibility for the mortgage you desire will determine whether or not a 401(k) withdrawal is preferable to a traditional IRA withdrawal.

  • Contributions to a Roth IRA are exempt from both income tax and the 10% penalty.
  • Earnings in Your Roth IRA up to $10,000 for the Purchase of a First Home: No income tax is owed and no 10% penalty is incurred.
  • Small 401k Loan: No income tax or penalty is due. The monthly payments will be modest and will have a negligible impact on mortgage eligibility.
  • Any Withdrawal Up to $10,000 From a Traditional IRA, SEP-IRA, or SIMPLE IRA for the Purchase of a First Home: No Income Tax Due, No 10% Penalty
  • Profits inside Your Roth IRA Over $10,000 for the Purchase of a First Home: You will owe income tax and a 10% penalty.
  • Any Withdrawal Over $10,000 From a Traditional IRA, SEP-IRA, or SIMPLE IRA: Income tax is required and a 10% penalty is owed.
  • Large 401k Loan (Limited to Half of Balance or $50,000, Whichever Is Smaller): No tax or penalty is due. Monthly payments can be hefty and significantly impact mortgage eligibility.
  • Any 401k withdrawal will incur income tax and a 10% penalty.

Bottom Line

Since I used funds from my individual retirement account (IRA) to fund the downpayment on our home, I consider myself very fortunate. It might take a considerable amount of time to save enough for a down payment.

Get a mortgage as soon as possible to start saving on rent and taking advantage of annual tax deductions for mortgage interest. In addition, you may take out up to $10,000 tax-free from these accounts to go toward your first home’s renovation or repair.

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