Tuesday, August 2, 2011

Can you take money out of your 401K to buy a home?

Can you take money out of your 401K to buy a home?


I want to thank Jenny Barnes from JLB Tax Services for providing information on this subject. Jenny can be reached at jenny@jlbtaxonaut.com or visit her website http://www.jlbtaxonaut.com for additional information


Using Your IRA for a Home Down Payment


The IRS discourages you from withdrawing money from your retirement accounts early by charging a 10% penalty on withdrawals before you turn 59 1/2.


Roth IRA


Among the various kinds of retirement accounts, pulling money from a Roth IRA will cost you the least in taxes and penalties. This is because you can withdraw contributions at any time without penalty or tax. In addition, after you’ve held the account for five years, you can withdraw up to $10,000 in earnings without penalty or tax for the purchase, repair, or remodel of a first home. In other words, if you withdraw all of your contributions, you can still withdraw another $10,000 and not pay the 10% penalty or taxes on any of it.


There is one caveat however: you only have 120 days to spend withdrawn earnings or you may be liable for paying the penalty. Also, for your convenience, your financial services firm will automatically prioritize the withdrawal of all of your contributions from a Roth IRA before any earnings.


Traditional IRA


The next best choice is a traditional IRA. You’re still able to withdraw up to $10,000 for the purchase, repair, or remodel of a first home without paying a penalty, but you’ll have to pay regular income tax on the entire amount. SIMPLE and SEP IRAs follow the same rules.


With a traditional IRA, you must also use the money within 120 days for the purchase of a home or you’ll get hit with the 10% penalty. Alternatively, you can withdraw up to $10,000 penalty-free for the purchase of a home for your spouse, parents, children, or grandchildren.


Just like with a Roth IRA, your spouse can also withdraw $10,000 from his or her traditional IRA, so you can collectively obtain $20,000 penalty-free for a down payment if you’re married. The $10,000 limit is a lifetime limit for each individual.


Using Your 401k for a Down Payment


If you take money out of your 401K to buy your first home, you’ll be assessed a penalty of 10% on the amount withdrawn and you’ll have to pay income tax on it as well.


If possible, roll over the amount you want to withdraw to an IRA, so you can avoid paying the penalty. However, you can’t roll over a 401k that’s with an employer for whom you are still working. If you have an old 401k from a former employer, roll that. Since a rollover can take time to process, fill out the necessary paperwork as soon as possible.


Borrowing from Your 401k


Another option with a 401k is to take out a loan. Your loan can be up to $50,000 or half the value of the account, whichever is less. As long as you can handle the payments (yes, you have to pay back this loan), this is usually a less expensive option than a straight withdrawal. Though you will pay interest, you won’t pay taxes or penalties on the loan amount.


A few things to know about 401k loans:


Since you’re incurring debt and will need to make monthly payments on the loan, your ability to get a mortgage may be affected.
The interest rate on 401k loans is generally about two points above the prime rate. The interest you pay, however, isn’t paid to the company – it goes into your 401k account.
Many plans give you only five years to repay the loan. In other words, if you borrow a large amount, the payments could be substantial.
If you leave your company, you may be required to pay back the outstanding balance within 60 to 90 days or be forced to take it as a hardship withdrawal. This means you’ll be hit with taxes and penalties on the amount you still owe.
If payments are deducted from your paycheck, the principal payments will not be taxed but the interest payments will be taxed. Since you’ll be taxed again on withdrawals during retirement, the interest payments will end up being double-taxed.

Sometimes it makes sense to take a loan from your 401k to cover the down payment, like if you are getting an FHA loan and only need a small down payment. However, a large loan payment could have a big effect on your mortgage qualification.


Therefore, it is wise to run numbers and ask your mortgage broker how such a loan will affect your qualification before you take one out. Conversely, if the amount you need will have too adverse an effect on your qualification, it might make sense to withdraw the down payment amount and pay the taxes and penalties.







Carla Dimond

Lifesystle Neighborhood Specialist

Keller Willliams-Cupertino

650.388.8820

carla.dimond@gmail.com

www.findahomeinsiliconvalley.com

2 comments:

  1. Hi Carla,

    This is a great article. One point of clarification; often, with certain investors, a 401k loan is not counted against the borrower for purposes of Debt-To-Income when purchasing a home. In a strange way, the underwriter looks at the payments made as paying yourself back and not a "true" debt. Of course this is on a case-by-case basis and a mortgage professional should be contacted first.

    -Rob Pavley

    ReplyDelete
  2. Rob

    Thanks for the clarification!

    Carla

    ReplyDelete