A 401(k) is a powerful investment account created for retirement savings. It is typically funded by contributions from your salary, allowing you to claim a tax deduction and see tax-free growth in your investment over time. Furthermore, employers may match contributions, and the account benefits from high contribution limits and federal protections. Generally, the funds are not taxed until they are taken out for retirement.
While 401(k) accounts have strict access rules—meaning you can typically only access the money without penalty if you are over 55 and no longer employed—homeowners are allowed to use these retirement funds as a source of cash for a down payment on a house.
Withdrawals before the designated time normally result in a 10% penalty fee on the amount taken out, and the amount becomes exposed to income tax. However, if you are a first-time homebuyer, you can withdraw up to $10,000 toward your down payment without incurring the 10% penalty.
If you plan to use your 401(k) for a down payment, you have two primary options: Borrowing or making a withdrawal.
Option 1: Borrowing from Your 401(k):
Borrowing involves taking a loan from your retirement account, which must be repaid.
- Loan Terms: The loan term is typically five years, with an interest rate that is one or two points higher than the prime rate.
- Limit: The maximum amount you can withdraw is the lesser of $50,000 or 50% of your vested balance.
- Mortgage Qualification Benefit: A 401(k) loan is not counted toward the debt-to-income ratio (DTI) and is not reported to credit bureaus. This means your eligibility to qualify for a mortgage won’t be impacted.
- Penalties: If you are under 59.5, you can avoid the 10% early withdrawal fee, and the amount withdrawn will not be subject to income tax. However, if you change employers or cannot pay the loan back for any reason, you may be subject to paying income tax and the 10% penalty.
Option 2: 401(k) Withdrawal:
This is taking the funds out of the account with no expectation of paying them back. You do not have to worry about repayment with this option, but you will likely have to pay income taxes and a 10% penalty for early withdrawal. You can qualify for a penalty exception if you are a first-time home buyer (up to $10,000) or if you lost your home due to a federally declared disaster (up to $22,000).
Before moving forward, it’s crucial to evaluate both options and how they will affect your financial/retirement goals by discussing this with a financial advisor, your 401(k) fund manager, and a tax professional.
If you have any questions about using assets from your 401(k) or other asset accounts for a down payment, give us a call at (760) 930-0569 to discuss your mortgage options.
