How to Draw from Your 401k to Make a Home Down Payment
A substantial down payment is usually beneficial for the average home buyer. Not only does it reduce the principal of the loan and thereby lower monthly payments, but it can also help a homeowner avoid having to pay for Private Mortgage Insurance (PMI). However, not everyone has the recommended 20% of the price of a home sitting in their savings account. That's why some people will take funds from their 401k in order to pay for their home. How does a potential home buyer draw down a 401k to make a down payment on a home?
How It Works
There are typically two different ways, through a loan or hardship withdrawal, that a home buyer can take funds from their 401k:
- Loan: This option is essentially the equivalent of taking a loan from yourself. A Green Valley home buyer can take up to half the funds in their account, up to $50,000 as a non-taxable event. They can then set themselves up on a payment plan to pay the funds back. Loan payment schedules cannot last longer than five years, so buyers should calculate and budget their payments prior to taking out the money.
- Hardship: The IRS offers people a way to take money from their 401k if they fall on difficult times. It is not generally recommended for home buyers because it's fully taxable and can result in a 10% penalty if the holder is under 59.5 years old.
Hardship rules have to be directly related to the buying or construction of a new home, and the IRS may require buyers to present the sales contract, building permit, or good faith estimate before approving the withdrawal. Typically, this option would be reserved for those who need more than $50,000 from their 401k.
How to Decide
A person's 401k is extremely prudent for planning ahead, and there's a reason why experts say to leave it alone for as long as possible. However, the long-term savings of borrowing from a 401k can be worth the risk. PMI can add up to 1% of the total cost of the home for every year a home buyer needs it. Homeowners must pay PMI until they reach 20% equity in their home, which could take years. The higher an owner's loan to value ratio, the more money goes toward interest and insurance rather than reducing the cost of the principal. Borrowing a loan from a 401k means the majority of money is going back to you rather than to a private mortgage insurer or lender.
It's worth noting that a 401k loan has a few additional details home buyers should consider. For starters, the holder will need to pay back their loan with interest. Usually, it's the Prime Rate (i.e., the lowest allowable rate at which money can be borrowed) plus an additional 1%. And while the rate may be attractive, buyers need to pay their loan with money that's already been taxed. Buyers who miss a payment will be considered in default of the loan, which means the loan balance will become a part of a buyer's annual income. Once this happens, the balance will be taxed at the buyer's normal annual income tax rate.
Talking to a financial planner or a real estate expert is the best way to crunch the numbers and decide the best option. Home buyers may need to run the numbers in a number of different scenarios, and a professional can make it easier to come out ahead.