So you want to buy a home, but you don't have enough money to come up with a down payment. Good news. You can withdraw from your 401(k) or IRA to buy a home.
You can take up to $10,000 out of your IRA penalty-free for a first-time home purchase. If you are married, your spouse can do the same – and “first-time home” is defined pretty loosely.
According to the IRS, the loan has to be for a first-time home and you must not have had ownership interest in a home for the past two years. This doesn't make sense to me, but that's what the IRS says.
There’s no specific penalty exemption for home purchases when you pull money out of a 401k, so any money you take out will be classified as a “hardship exemption.” You’ll be assessed a penalty of 10% on the amount withdrawn and you’ll have to pay income tax on it as well.
If possible, roll over the amount you want to withdraw to an IRA, so you can avoid paying the penalty. However, you can’t roll over a 401k that’s with an employer for whom you are still working. If you have an old 401k from a former employer, roll that. Since a rollover can take time to process, fill out the necessary paperwork as soon as possible.
Be Careful Buying A Home Today
Withdrawing from your pre-tax retirement accounts to the borrow money from the bank to buy your first home at this point in the cycle is risky. Yes, I believe the housing market will continue to stay strong. However, prices are at record highs. If you borrow money to borrow money, such a move could literally wipe away your entire net worth in a few short years if the real estate market turns south and you've got to sell.
Instead, you're much better off building your after-tax savings and investments that can provide for a 20% downpayment. If you don't have at least a 20% downpayment in cash plus a 10% buffer, you probably cannot afford to buy your first home.
Renting is good value now in many parts of the country, especially if you live in an expensive coastal city. Take a look at my BURL strategy if you really want to invest in real estate.
Alternative Way To Invest In Real Estate
Personally, I've sold one expensive San Francisco rental home in 2017 and reinvested $550,000 of the proceeds into real estate crowdfunding investments in the heartland of America. Valuations are so much cheaper and the net rental yields for earning passive income are so much higher.
My favorite real estate platforms are Fundrise for non-accredited investors and CrowdStreet for accredited investors. Fundrise offers diversified eREITS. CrowdStreet offers individual commercial real estate projects where you can build your own portfolio.
Real estate crowdfunding has allowed for the more efficient deployment of real estate capital that was only available to institutional investors or ultra high net worth individuals.
The 401(k) Loan: Better, But Not Ideal
The IRS allows you to borrow against your 401k, provided your employer permits it. If your plan does allow loans, your employer will set the terms.
The maximum loan amount permitted by the IRS is $50,000 or half of your 401k’s vested account balance, whichever is less. During the loan, you pay principle and interest to yourself at a couple points above the prime rate, which comes out of your paycheck on an after-tax basis.
Generally, the maximum term is five years, but if you use the loan as a down-payment on a principal residence, it can be as long as 15 years. But who plans to stay at an employer for 15 years anymore? Not many.
Borrowing from your 401(k) is a good alternative because you do not need a credit check, nothing appears on your credit report, and interest is paid to you instead of a bank or credit card company.
Try Not To Touch Your 401(k) Or IRA
Given 401(k) and IRA contributions are pre-tax contributions, it makes sense there would be penalties assessed for early withdrawals from the government's point of view. Why would the government allow you to not pay taxes and then allow you to earn tax-free compounding and then withdraw the founds?
I could have been a 401(k) millionaire had I kept working at my job until age 40. The power of compounding is real!
If you need money to come up with a downpayment for a home, consider going through the following alternatives first:
- Savings – if the amount of money you are saving each month doesn't hurt, you're not saving enough
- After-tax investments – if you want options, you need after-tax investments generating passive income
- Side job income – there are so many ways to make extra money than from a day job
- Borrow money interest-free from a friend or family member – you need to have good relationships in order to do so
- Roth IRA
- 401(k) or IRA
Roth IRA Is A Better Choice Than A 401(k)
With the Roth IRA, since you've already paid taxes on your contributions, you can withdraw contributions you made to your Roth IRA anytime, tax- and penalty-free. However, you may have to pay taxes and penalties on earnings in your Roth IRA if you've held for less than five years.
After you’ve held the account for five years, you can withdraw up to $10,000 in earnings without penalty or tax for the purchase, repair, or remodel of a first home. In other words, if you withdraw all of your contributions, you can still withdraw another $10,000 and not pay the 10% penalty or taxes on any of it.
Please don't withdraw from your 401(k) or IRA to buy a house. Let your pre-tax retirement contributions grow and compound over time. Keep your FOMO for a house at bay. There's nothing wrong with renting now that real estate prices all around the country have reached record highs.
Recommendation To Build Wealth
Manage Your Money In One Place. Sign up for Personal Capital, the web’s #1 free wealth management tool to get a better handle on your finances. In addition to better money oversight, run your investments through their award-winning Investment Checkup tool to see exactly how much you are paying in fees. I was paying $1,700 a year in fees I had no idea I was paying.
After you link all your accounts, use their Retirement Planning calculator that pulls your real data to give you as pure an estimation of your financial future as possible using Monte Carlo simulation algorithms. Definitely run your numbers to see how you’re doing. I’ve been using Personal Capital since 2012 and have seen my net worth skyrocket during this time thanks to better money management.
About the Author: Sam started Financial Samurai in 2009 as a way to make sense of the financial crisis. He proceeded to spend the next 13 years after attending The College of William & Mary and UC Berkeley for b-school working at Goldman Sachs and Credit Suisse. He owns properties in San Francisco, Lake Tahoe, and Honolulu and has $810,000 invested in real estate crowdfunding.