Buying a home is an important financial milestone. In fact, it’s most likely one of the largest purchases you’ll make in your lifetime. You may be tempted to make a 401(k) withdrawal for a home purchase, especially if you need to make the down payment. Let’s break down whether you should make a 401(k) withdrawal to buy a home and other alternatives.
A financial advisor can help you create a financial plan for your home buying needs and goals.
Can You Make a 401(k) Withdrawal to Buy a Home?
Whether you can make a 401(k) withdrawal for a home purchase depends on your age and plan. If you’re less than age 59.5, this withdrawal is an early withdrawal. The rules around early withdrawals will be outlined in your 401(k) plan. For instance, your employer may require extra documentation for you to make a case for the withdrawal.
You may have also heard that you can make a 401(k) hardship withdrawal to buy a house. This isn’t true. The benefit of a hardship withdrawal is that it waives the early withdrawal fee. While this is an option if you become disabled or have medical expenses, the IRS explicitly says it’s not an option for home buying.
What to Consider Before Making a 401(k) Withdrawal
In most circumstances, with an early withdrawal, you’ll face a 10% fee on any amount you withdraw. For example, if you withdraw $10,000, you’ll pay a $1,000 fee. Along with the fee, you’ll need to pay income tax on whatever you withdraw from your 401(k). So, if you face a 20% income tax on top of the early withdrawal fee, your $10,000 withdrawal just becomes $7,000.
The other thing to consider is the opportunity cost of withdrawing from your 401(k). In other words, what will that cost you in retirement if you pull out money now to make a down payment? Let’s work out an example with our 401(k) calculator.
Say you pull out $10,000 from your 401(k) at age 35. Assuming a conservative annual return rate of 4%, that $10,000 will be $33,731 by the time you turn 66. In 31 years, that money more than tripled, earning you $23,731 just by sitting in your 401(k).
Should You Use Your 401(k) to Buy a House?
While every person and situation is different, making an early withdrawal from your 401(k) is generally regarded as a bad idea. Other savings or assets should be tapped first before turning to your 401(k). There’s a reason the IRS puts a hefty 10% early withdrawal fee on 401(k)s: It wants to actively discourage people from using them for anything other than retirement.
Making a 401(k) withdrawal for a home purchase should be a last resort. If you have other options, you should exhaust them first.
Alternative Options to a 401(k) Withdrawal
It’s essential to know your options before making big financial decisions. Whether it’s your retirement savings or funding a home purchase, knowing how money works is key to making it work for you. Here are five things to consider before withdrawing from your 401(k):
Put off home buying. If you don’t have enough for a down payment and closing costs, your best option may be to wait. You can continue saving and looking for other opportunities to grow your income. Consider picking up a side hustle or turning a hobby into a business. Focus on building your credit so you can qualify for a mortgage and get more favorable terms.
If you have any assets, consider selling them to turn them into savings for your new home. These could include things like a spare car, jewelry or other valuables.
Research different mortgage options. Different mortgages have different down payment and credit requirements. For instance, you can qualify for an FHA mortgage with a credit score of 580 and a down payment of 3.5%. With conventional mortgages, you can get one with as little as 3% down and a credit score of 620. Though, keep in mind that, with a lower down payment, you’ll have a higher interest rate and will need to pay mortgage insurance.
If you’re eligible, VA and USDA loans don’t require down payments, but they do have requirements for getting them. With VA loans, you’ll need to meet the military service requirements. On the other hand, USDA loans have income limits and rules on where you can live.
Research down payment assistance. Many states and local governments offer down payment assistance programs. These programs often come in the form of down payment grants or loans. They are specific to your location, so you must research their requirements. In general, you will need to make below a specific income limit. They may also require that you’re a first-time homebuyer.
Use your IRA. You may be able to take advantage of the IRS’s exception on the 10% early withdrawal fee if you withdraw from an IRA. Here are three general rules:
- You’re a first-time homebuyer or haven’t owned a principal residence in the past two years.
- Only used for qualified acquisition costs, such as closing costs.
- There’s a lifetime withdrawal limit of $10,000.
Take out a 401(k) loan. A 401(k) loan is often a much better option than an early withdrawal. Still, it should be considered after your other options have failed. A 401(k) loan is you borrowing from yourself and can often be easier to get than other types of loans. It’s not free, however, you’ll need to pay interest on the loan.
Your first step toward taking out a 401(k) loan is contacting your HR department. They’ll be able to walk you through whether a loan is possible, and if so, what requirements must be met for you to take one out.
Making a 401(k) withdrawal for a home purchase isn’t the best option. If you can do it, it can cost you a lot in fees and taxes. It’s best to explore other avenues before making an early withdrawal from your 401(k). Research what mortgages you may qualify for with lower down payments and whether you’ll qualify for home buying assistance.
Tips on Home Buying
- A financial advisor can help you get your money and credit ready to buy a home. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- When shopping for a mortgage, you want the best interest rate while avoiding hefty fees. Use SmartAsset’s mortgage comparison tool to compare mortgage rates from top lenders and find the one that best suits your needs.
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