FINANCE
Can you use your 401(k) to buy a house?
Yes, it is possible to use your 401(k) funds to buy a house but if you withdraw the money before a certain age you will pay a penalty.
Saving for a deposit can be a challenge when buying a home. However, your 401(k) can be a potential source of funds to help you reach your goal. Depending on your retirement plan’s provisions, you may consider either taking a 401(k) loan or withdrawing funds directly from your account. Each method comes with its own set of advantages and considerations. Let’s explore the options.
Funding a house through a 401(k) plan loan
One of the most favorable options is to apply for a 401(k) loan. This avoids the 10% early withdrawal tax penalty and since you are borrowing from yourself, there are no tax penalties, and the borrowed amount is not taxed as regular income.
Debt owed to your 401(k) after a loan is not factored into the debt-to-income ratio (DTI) calculation, which can enhance your chances of qualifying for a mortgage.
What is a debt-to-income ratio?
The debt-to-income ratio refers to the percentage of a person's monthly gross income that goes towards housing expenses. To calculate DTI for housing, divide the total monthly housing expenses by the gross monthly income and multiply the result by 100. Lenders typically have maximum DTI thresholds, such as 28% to 36%, when considering housing loan applications.
Other benefits include the the loan not affecting your credit score or loan approval odds, as creditworthiness is not considered.
The maximum amount you can borrow from your 401(k) is generally $50,000 or half your vested balance within a 12-month period. Repayment must usually occur within five years with interest. However, if you leave your job the loan may become due immediately.
Funding a house through a 401(k) plan withdrawal
While withdrawing money from your 401(k) is an option, it is less ideal due to potential penalties. If you withdraw funds before age 59½, you will face a 10% penalty, in addition to paying income taxes on the withdrawn amount.
The IRS provides exceptions to the penalty for financial hardships, including home purchases. However, these exceptions are deliberately challenging to qualify for and require proof of financial hardship and the absence of other assets for home purchase, making this not a feasible option. Between the age of 55 and 59½ you can pull money out of a 401(k) plan in the event that you get laid off, fired or quit your job without being penalised.
The full amount that you pull out of a traditional 401(k) plan will be subject to a 10% penalty in addition to income taxes. Whereas, because you already paid taxes on the money that you put into a Roth 401(k) plan you’ll pay a pro-rata amount of your contributions, which are non-taxable, and earnings, which are taxable.