If you’re planning to buy a home in the near future, you’ll need some form of down payment to secure a mortgage. The thing is, it can be downright difficult to gather up the funds needed to put a decent-sized down payment towards your home purchase. With housing prices being what they are today – especially in more expensive centers like San Francisco – coming up with a down payment relative to the purchase price is a major feat.
Fortunately, there are various sources of funds that you may be able to tap into besides your savings account. One resource you may want to consider is your 401(K) to access the money needed to use for a down payment. However, you could be penalized for withdrawing these funds early and can lose tax breaks associated with these retirement savings.
The question is, how can you use your saved-up retirement funds for a down payment without being slapped with penalties for doing so?
Take Out a Loan From Your 401(K) For a Down Payment
Your 401(K) account was developed and contributed to for a specific reason: to help you save up enough money to be used in your retirement years. As such, it might not seem to make much sense to tap into this account for other reasons. However, you can still benefit from these savings without compromising your long-term financial goals.
If you take money out of your 401(K) account, you’ll most likely be subject to a 10% early withdrawal penalty fee if you’re under the age of 59.5 years. Not only that, you’ll also need to pay income taxes on that money, which might not seem like withdrawing money from this account would be worth it after all.
However, there are ways for you to use your retirement funds without being penalized. For starters, you may consider borrowing from your 401(K) account rather than actually pulling money out of the account for good.
With this method, any principal and interest that would need to be repaid would go to you, not the bank. In essence, you’re borrowing from yourself and not your lender. You can choose to either pay back the amount in regular installments or in lump sums.
Like a typical loan, you are responsible for making your payments on time and in full in order to avoid any penalty fees or taxes. Given this fact, borrowing against your 401(K) only makes sense if you’re willing and able to handle your designated repayment schedule.
That said, a 401(K) loan may be your best option if you don’t have enough money for a down payment and don’t have any financial support from family members.
When taking out a loan from your 401(K) account, you can borrow as much as $50,000 or half of your account’s value, whichever is less. Any interest associated with the repayment schedule goes straight back into the account, though you are still required to pay it in full.
Roll Your Withdrawal Amount Into Your IRA
Another option you may have when tapping into your retirement funds to come up with a sizable down payment is to roll over the amount of money you need from your 401(K) into an IRA. Done right, doing so will also help you avoid having to pay any penalty fees associated with taking out these funds before you reach retirement age.
By taking the roll-over approach, you’ll be able to take advantage of the same type of exemption that first-timers get when they use money from their IRA accounts to beef up their down payments.
The penalty exemptions associated with an IRA depends on the type of account you’re rolling into:
Roth IRA – You don’t have to worry about being stuck with a 10% early withdrawal fee or tax payments with a Roth IRA. You can take out $10,000 without penalty or tax if you’ve had your Roth IRA for a minimum of 5 years, as long as it’s used for your first home purchase.
Traditional IRA – While you won’t be subject to the 10% early withdrawal penalty fee if you pull out up to $10,000 to be put towards a down payment on your first home, you’ll still have to pay income taxes on the money withdrawn. Also, the money needs to be used within 120 days for a home purchase in order to avoid the 10% penalty.
The major caveat here is that you can’t roll over a 401(K) that’s still with an employer that you’re still working for. Rolling your 401(K) only works on accounts from former employers. Generally speaking, you’re only able to roll over a 401(K) to an IRA after you leave a company.
Once you leave a job, you can take your employer-sponsored 401(K) with you. By rolling it over, you can transfer the balance into another retirement account without having to pay taxes on that amount. In many cases, the best option is to roll the 401(K) into an IRA.
The Bottom Line
Getting some financial help when it comes to building a down payment for a home purchase might be necessary if your savings account is marginal. In this case, your 401(K) and IRA accounts may serve you well.
However, it’s always a good idea to think long and hard before borrowing against your retirement account. Not only do you want to make sure that your retirement savings are ample by the time you reach the Golden Years, you also don’t want to put yourself in the position to be subject to penalties. Be sure to speak with a financial advisor first before making any significant decisions about borrowing from your 401(K).