First-time homebuyers may use various financial strategies to save for a down payment. In some cases, they may even opt to withdraw funds from their 401(k) plans if they meet certain requirements.
The IRS allows individuals to withdraw funds from their 401(k) plans if they experience financial hardship. What counts as a hardship? The IRS lists medical expenses, funeral expenses, and expenses related to a FEMA-declared disaster. Additionally, the IRS counts the need to purchase a primary residence as one of their permitted 401(k) hardship withdrawal reasons.
If you wish to purchase a home using a 401(k) hardship withdrawal, you should first check the rules for your company’s plan. Not all plans permit 401(k) withdrawals. If your plan allows for this transaction, you’ll need to understand and prepare the required documentation to remove funds for a home purchase.
The 401(k) hardship withdrawal rules
Before requesting a hardship withdrawal, familiarize yourself with the rules surrounding these transactions. The IRS defines hardship as an “immediate and heavy” need. For a first-time home purchase, the following restrictions apply:
- You must pay income tax on the amount you withdraw.
- If you are under the age of 59 ½, you must pay an additional 10% income tax for a hardship withdrawal related to buying a home.
- You cannot use the funds to pay your mortgage when making an initial purchase.
- The amount you can withdraw is limited to the funds needed to assist with the home purchase.
To approve your request for a hardship withdrawal, your employer will require documentation of your financial need. Your employer may also ask for proof that other options, such as a second mortgage loan, are unavailable.
Also, note that you cannot “catch up” the withdrawn amount by paying extra into your 401(k). While you can still contribute the annual maximum amount allowed by the plan each year, you cannot compensate for the funds distributed with additional future contributions.
Alternatives to a hardship withdrawal
A hardship withdrawal helps you buy a home, but you should also understand the long-term financial consequences when taking money out of your retirement savings account. Not only will you lose the amount already saved in your 401(k), but you’ll also lose future earnings related to the withdrawn funds. You could also pay additional taxes on the money withdrawn.
If you need a larger down payment or money for closing costs, consider the following options before resorting to a hardship withdrawal:
Many 401(k) plans allow participants to take a loan and pay it back with interest. This option offers advantages to a hardship withdrawal. It avoids tax on the funds received. You’ll also pay back the borrowed amount to your retirement account.
If you save money through an IRA, you can take advantage of a first-time homebuyer withdrawal of $10,000 to put toward a down payment. Unlike a 401(k) hardship withdrawal for home buyers, the IRA withdrawal is exempt from the additional 10% tax penalty assessed for early withdrawals.
You may also use gifted funds from friends or relatives for your down payment, as long as the giver signs an acknowledgment stating that they do not expect repayment.
A second mortgage, like a piggyback loan, allows you to borrow an amount in addition to your primary mortgage to reach the 20% down payment threshold. In this situation, the homebuyer typically pays 10% for the down payment, and the secondary loan covers the remaining 10%.
Waiting to buy
Depending on the local real estate market and predicted future trends, you may simply decide to wait to buy and continue saving for a down payment. To keep on track with saving, consider using an automated savings plan to take money directly from your paycheck and divert it into another account before you’re tempted to spend it.
First-time homebuyer programs
Numerous government and private programs offer assistance to first-time homebuyers to avoid a 401(k) loan or withdrawal. Start by asking your lender if they run or can help connect you with first-time homebuyer programs. Individual states also offer first-time buyers incentives to help with home purchases. Community nonprofits or neighborhood alliances may also step in to assist with down payment funds in targeted areas.
FHA loans allow you to buy a home with lower credit scores and a down payment as low as 3.5%. You can run a search for an FHA-approved lender online. With an FHA loan, you still must pay for mortgage insurance, but you can refinance your loan at a later date to take advantage of better rates and terms. Qualifying veterans also have access to VA loans, which do not require a down payment or mortgage insurance.
Paying less than 20% down and paying for PMI
Depending on the amount of your down payment shortfall, you may wish to proceed with your home purchase and agree to pay for private mortgage insurance (PMI). You may find that paying for PMI for the first year or two of your mortgage is less than the costs and long-term earnings lost due to a 401(k) hardship withdrawal.
Lenders typically offer buyers preferred rates and mortgage terms with a 20% down payment. If you’re falling short of this mark, price out all of your options to determine which one makes the most financial sense. You may need to combine funds from sources such as personal savings, a 401(k) loan, and down payment assistance to achieve the desired 20% target. Based on the current real estate market or your personal circumstances, you may decide to move forward with a lower down payment. If so, you can look into an option like an FHA loan, with the hopes of refinancing for better terms at some point in the future.