With home prices being so expensive, the cost of living on the rise, and wages remaining steady – you may be looking at your 401K as a good source of down payment money.
Here are a few things you need to know before you make this decision.
Two Options: Borrow or Withdraw
When using your 401k to fund your down payment, you have two options. You can make a formal withdrawal from your account, or you can obtain a loan from your 401K account. Both of these options are complicated and less than ideal, but doable depending on the fine print of your contract.
Making a Withdrawal
Withdrawing funds from your 401K should always be a last resort option. Your withdrawal will be considered a “hardship withdrawal” – generally, paying for the down payment on your primary residence will be considered a hardship by the IRS and you’ll be able to get the money without problems. Recent law changes actually allow you to withdraw not only your own contributions, but employer contributions as well.
However, if you are under 59, you will likely incur a penalty tax of about 10% for taking this money out too early. You will also owe income tax on your withdrawal, since all contributions are tax free. Additionally, you are typically only allowed to take out half of your vested balance, or up to $50,000 – whichever is lower. If you have $10,000 or less in your account, your bank may allow you to withdraw without limitations.
Borrowing From Your 401K
Of the two options, a 401K loan is definitely more desirable than a withdrawal. There are less consequences, but there is still a lot to consider before making this move.
Pros of a 401K Loan
- You are borrowing from yourself.
- Your interest payments are going back into your account (not to a bank).
- You can borrow the same amount you can withdraw – $50,000 or 50% of your vested balance – whichever comes first.
Cons of a 401K Loan
- Strict repayment timeline. You’ll usually need to pay off the balance within 5 years.
- Loss of investment growth on your 401K.
- You might not be able to add to your 401K until the loan is closed.
- If you change jobs, you’ll have to pay off your loan before you submit your income taxes. If not, the loan may be considered a withdrawal. In this case, you’ll owe the penalty tax and income tax on the funds.
Withdrawals and 401K loans both have some perks – however, the cons far outweigh the pros. If your financial situation is not stable enough to ensure that you can get a good loan to begin with, you may not want to put yourself in a situation where your retirement funds are on the line.
A better option is to continue to save up for your down payment, and consider assistance that won’t involve insane interest payments. Home LLC offers assistance for aspiring homeowners in exactly this situation, with an interest free down payment investment that can make homeownership achievable for those in a rough place financially. Don’t put your future on the line and give us a call so we can help you get the home of your dreams!