How to Use Funds in Your 401K to Fund a Down Payment
Updated: May 21, 2020
It's getting harder to keep up with living costs, much less save for a down payment. The great news, of course, is that a 20% down payment is not the required norm anymore. Even so, with the lower down payment options available these days, getting the 3 - 3.5% can be the only obstacle in your way to becoming a homeowner at last. In this article, we will explore options to use funds from your 401k to fund your home. We also discuss some tips so that you avoid penalties and don’t lose out too much on retirement benefits.
Moving funds from your 401K to your IRA
If you have some funds from previous employers lying in a 401K, you could move some of this over to your IRA. You have the option of rolling it toward your traditional or ROTH IRA if you have one.
You need to be aware though, that the amount you roll into your ROTH IRA will be taxed as income unless your 401K plan is specified as a ROTH 401K. In which case, the rolled amount will not incur income taxes.
For this option, you need to open a rollover IRA account if you don’t have one. This is not complicated, and you will get to specify your investments, including the intention to withdraw your down payment amount.
The way to do this is to ask for a direct rollover - so the funds go directly into your IRA. Note that if you have it cashed out, or the cheque is made out in your name, a very large cut of that will be owed to the IRS, certainly more than 10%!
You are allowed to withdraw $10 000 towards the purchase of your first home without any penalty. This applies both to traditional and ROTH IRA. Any withdrawal over this amount will be penalized, along with the obvious income tax addition.
Taking a loan from your 401K
When a withdrawal gets complicated, a 401K loan may just be an option for you.
The loan has a term of 5 years maximum, and the limit is either $50 000, or up to half your 401K funds, whichever is less. In either case, there is no income tax, nor a penalty applicable. A small loan of $10 000 or less is considered a smart move in this instance.
This option is a speedy one, funds will reflect in your account within the week.
A loan remains such and needs to be repaid, and at a slightly higher interest rate than prime. Consider, though, that this interest is not paid to some institution but back into your own account. Neither you nor your employer may make any contributions to your 401K until the loan is repaid in full.
Remember also that mortgage interest is tax-deductible. So, in the end, the interest paid on your 401k loan can be gained back to a degree by your tax deductions, depending on the size of your loan.
Also remember, should you leave your current employer or lose your job, this loan becomes repayable within 60 days. There is a softening provision in that if you are not able to make such repayment, this will default from a loan to a withdrawal. It becomes subject to the 10% penalty and income tax liability.
A loan amount may negatively affect mortgage eligibility. Consider talking to one of our agents before going ahead with this option, so they can pair you with the right professional adviser(s). If taking this loan will cause your disqualification from taking out a mortgage, it is not only pointless but also forbidden by the IRS. ((Reg. Section 1.401(k)-1(d)(3)(iv)(D))
If you have a good credit rating and are given the green light, then you may benefit most from taking a small 401K loan, as opposed to a large one. Paired with a low down payment loan option, such as an FHA loan, your payments will be minimal and free you to enjoy more of your hard-earned money.
Withdrawing directly from your 401K
A normal 401K withdrawal will incur a 10% penalty as well as income taxes. Your withdrawal needs to be classified as a ‘hardship withdrawal’. Although a down payment for a principal residence falls under this category, it will still induce the 10% penalty.
Since 2019, a withdrawal from your 401k has become a lot more accessible with the new Bipartisan Budget Act Changes.
Whereas before you could only withdraw against your own salaried contributions, that limit has now fallen away. You can now take a larger withdrawal as needed.
You no longer need to have taken a plan loan before qualifying for withdrawal.
Withdrawing directly does not limit your contributions as would a loan from your 401K while you are also still eligible for employer contributions. This lessens the impact on your retirement savings to an extent
There is no limit to the withdrawal you can take within your available funds. Yet, you need to specify the exact amount to cover your specific needs under the hardship withdrawal type. This may include the income tax as well as penalties incurred.
Your withdrawal also depends on your employer and the type of plan you have with them.
Long term tip: While incurring income tax may be a bit of a blow, it may be advisable not to include this in your 401K withdrawal. Keeping your withdrawal to a minimum will protect your retirement to a degree.