401k Withdrawal To Purchase A Home
Many buyers inquire about whether it makes sense to take a 401k withdrawal to purchase a home. The answer may vary depending on each individual’s unique set of circumstances. Generally, however, taking a 401k withdrawal to purchase a home should be a last resort in order to avoid tax penalties in connection with the withdrawal. Alternatively and if necessary, buyers should consider taking out a loan against 401k funds, which enables the repayment of those funds back into the 401k plan.
401ks Generally
A 401k is a retirement account provided by many employers that allows employees to contribute a portion of their income to a tax-deferred account to save for retirement. Contributions to the account are tax-free until the time of withdrawal. Funds within a 401k account can be invested as provided by the employer’s plan, and growth within the account is also tax-free until the time of withdrawal. There are, however, restrictions on when purchasers can take a 401k withdrawal to purchase a home.
401k Withdrawal To Purchase A Home
All 401k withdrawals are taxable as ordinary income. If a withdrawal is taken before the age of 59 1/2, the withdrawal is subject to an additional penalty of 10%. There are several exceptions to the penalty, such as if the withdrawing individual has become totally disabled, but a 401k withdrawal to purchase a home is not one of the exceptions. Many investment advisers, such as Forbes, recommend against this approach in most circumstances.
There is, however, a way to avoid the penalty accompanying a 401k withdrawal to purchase a home in limited circumstances. If the 401k funds are in an account with a former employer, those funds can be “rolled over” into an Individual Retirement Account (IRA). IRAs allow a once-in-a-lifetime $10,000 withdrawal for the specific purpose of purchasing a home, penalty-free. Those funds will still be subject to the ordinary income tax, but will not be subject to the 10% penalty imposed by 401k withdrawals. If a home purchase is made early enough in the year, the mortgage interest incurred during the year in connection with mortgage payments may be enough to entirely offset the tax on the IRA withdrawal, making the IRA withdrawal option more feasible than a 401k withdrawal to purchase a home.
401k Loans To Purchase A Home
Some employers’ 401k plans allow employees to take loans against 401k funds, which enables employees to make use of 401k funds without incurring the ordinary income tax and 10% penalty accompanied by a straight withdrawal. By taking a loan against the 401k, the owner of the account essentially sells stocks or bonds owned in the account and lends those funds to him or herself. Typically, the loan must be repaid within 15 years at an interest rate of one or two percentage points above the Libor or Prime rate.
Whether this option makes sense will, again, depend largely on each individual’s unique set of circumstances. The situation in which it will likely make the most sense is where the additional funds are needed to generate funds sufficient to make a 20% downpayment. The cost of taking a loan against a 401k in this situation may be less than the cost of paying a higher interest rate and Private Mortgage Insurance accompanying a downpayment of less than 20%. If the option to take a loan is available, it will almost always make more financial sense than taking a 401k withdrawal to purchase a home.
In sum, there are many options alternatives available to taking a 401k withdrawal to purchase a home. Discuss your options with your mortgage broker and make sure you have assessed all your options before making a decision.
If you would like to further discuss how Esquire Real Estate Brokerage, Inc. can help you in the Los Angeles real estate market, feel free to give us a call at 213-973-9439 or send us an email at info@esquirereb.com.
