How to use your 401K to buy a house in Houston
Houston, one of the fastest growing cities in the country, attract home buyers for several reasons. But for a lot of aspiring homebuyers, securing a down payment becomes the biggest roadblock in achieving their goal of home ownership. Aside from closing costs and ton of paperwork, the would-be homeowners need to come up with a down payment. While some options allow for a 3.5% down payment, putting at least 20% down is recommended to avoid the monthly costs to cover mortgage insurance.
Those who struggle to secure the amount required look to their retirement fund (401k) for easy access to much-needed cash. Technically, it’s legal and doable there are a few factors to consider and the things you can do with the money are limited to say the least. If you’re having reservations or second thoughts about it, here’s a comprehensive guide that will help clarify how to use your 401k to buy a house in the greater Houston area.
Being a real estate training agency, we help aspiring homebuyers learn how to overcome their homebuying hurdles through a unique owner financing program. Through this type of financing, homebuyers make monthly payments just like they would a conventional mortgage with a 30-year amortization period and fixed interest without balloon payments. The best part is if you are able to qualify for a mortgage anytime in the future, you can switch to a conventional home loan without paying pre-payment penalties. Start the search for your home below and let us know if you find one in your budget and desired location. We will help you buy that home with owner financing.
A Quick 401(k) Review
The US Internal Revenue Service (IRS), 401(k) is a retirement plan that gives eligible employees an opportunity to save in their own retirement with tax advantages. The funds are deducted from the employee’s paycheck and the employer can match a portion of or the entire contribution. Named after the subsection of the Internal Revenue Code, Congress designed these company-sponsored retirement plans to encourage working-class professionals to save up for their retirement.
401(k) comes in two distinct arrangements:
An employee's taxable income is reduced to a certain amount and reported as tax deduction for an inclusive number of years. The money paid or its profits are non-taxable No taxes are due on the money paid or the profits it earns until it’s withdrawn.
Unlike the conventional 401(k) arrangement, taxes for the Roth plan are paid upfront. Beneficiaries who withdraw the cash after retirement get their cash fully with no additional taxes on the contribution or the profits earned over the years.
Can You Buy a Home with Your 401(k)?
The quick answer to that is yes! But there are a few caveats. They’re called retirement funds for a reason, they’re the funds you set aside and spend in your golden years. Access to these funds are technically limited since the money should be withdrawn before the account holder reaches the age of 60 (59 ½ to be exact), or before 55 for those who resigned or lost their job at that particular point.
If you’re asking what the caveat is, there is a 10% early withdrawal penalty based on the amount of money to be taken out. That’s on top of the income tax it will be subject to since it will lose its tax break from being a retirement savings account. It’s like putting an I.O.U on your own retirement fund with an interest. Plus, time spent on paying back what you loaned could be time spent growing your money.
Picture this, you have $20,000 on your 401(k) account at the moment. Withdrawing half of it to cover for a home down payment will only leave you with $10,000 to acquire a 7% annualized rate of return for the next 25 years. That leaves you with just $54,000 instead of having a whopping $108,000 should you have left the funds alone.
It’s quite tempting to tap into your 401(k) for easy access to cash which can be used to put a down on your dream home. But with the caveats that come with it, the question would have to be “should you?”
Buying a Home with Your 401(k)
There are other financing methods homebuyers can avail for their dream house, but in case funds remain to be a hurdle, you can choose between these two options to use your 401(k).
Make a Withdrawal
It’s just like making a withdrawal from your bank account. This option, will however, be seen by the IRS as a hardship transaction. The IRS Rules on 401(k) withdrawals stipulate that using funds from a 401(k) to compensate for a heavy financial need is deemed as a hardship withdrawal. Regardless if you’re going to use it for a down payment on your home, the transaction being classified as a hardship withdrawal is up to your employer. Account holders also need to present concrete evidence of hardship before the withdrawal is approved.
In any case, you are still eligible to the aforementioned 10% early withdrawal penalty. Exemptions in place for specific circumstances exist such as expenses for the purchase of a principal residence. The best way to go about it is to present other assets to be used for the purchase since qualifying for such an exemption is difficult to say the least. Even if you manage to secure the exemption, your withdrawal will still be deducted of the income taxes they’re entitled to.
401(k) loan applications)
Right off the bat, this is the better choice than a withdrawal because (a) your transaction will not be subject to the 10% penalty stated above and (b) the money you’ll receive from the loan will not be eligible for income tax deductions. Beyond that, a loan on your 401(k) won’t damage your credit score or your chances of qualifying for a mortgage since credit bureaus will not be counting this transaction to your debt-to-income ratio.
The downside to it is that not all employers include a 401(k) loan on their retirement packages. If its offered, getting a loan freezes your account and you could miss out on years of appreciation if you’re unable to pay it in full. You’ll also need to repay the loaned amount in full until the next tax filing date should you get laid off or file for a resignation. Not doing so will render the transaction a 401(k) withdrawal in the eyes of the IRS and, as such, will subject you to the 10% penalty on top of the income tax deductions.
Tapping into your 401(k) is a viable option if you’re having trouble coming up with a down payment if you’re in the market for a new home. While there are ways to work around the penalties, it will only be an excellent last resort for a source of cash. Consider applying for alternative options such as owner financing. Like a bank-approved homebuyer, you’ll have the freedom and flexibility to get the home of your choice. Moreover, this option gives you a 30-year amortization period with reasonable interest and a chance to rebuild your credit as each payment is reported t
Disclaimer: Shop Owner Finance/ TL Global is not a lender. We are a real estate training agency. The Content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.