The average employee’s 401(k) account isn’t what it used to be. Consider people with money in Vanguard employer-sponsored 401(k) retirement accounts. Their precious retirement savings drooped 20% (year-over-year) in 2022.
A person with a balance near the median (at the midpoint of all account holders) held $27K in 2022 — about $8K less than in 2021.
This isn’t just about falling stock values. Accounts are also down because some people need to pull money out for housing costs — either rents, or down payments on homes.
Does Pulling 401(k) Money Into a Down Payment Make Sense?
We are not financial advisers, so we can’t say a particular strategy makes sense in a given situation. We can, however, make a general observation. Gathering a down payment can be very difficult when home prices are high and interest rates are rising. If you lack the cash for a down payment, resorting to retirement funds could be the only way to become a homeowner.
If you have money in a 401(k) or in an individual retirement account, you may withdraw money whenever you need to. The best way to do it is to call a representative and set some of the funds aside as cash, so they are ready to be transferred to your regular bank account.
But isn’t raiding a retirement account risky?
Taking early withdrawals will pare down your retirement savings account. You’ll be able to invest more later, but for now, the withdrawn money won’t be there, and it won’t have a chance to rebound with the market.
On the other hand, you’ll be buying a home with it. If ever there were a good reason to tap funds, that would be it. And an investment in a home is highly likely to grow, assuming your new home appreciates in value over the years.
Granted, a retirement account is supposed to stay in place, helping you save for a comfortable life in your senior years. But let’s face reality. Getting a home rather than renting is also key to having autonomy and equity — both very important factors for getting older on your terms.
☛ But is this really the right time to buy? Couldn’t the real estate market go down from here? If you have concerns…Read our take on protecting the value in your home equity.
What Are the Penalties for Pulling Money Out Before Age 59½?
If you are at least 59½ years old, you can pull money from your retirement account. The Internal Revenue Service deems everyone who turns 59½ eligible to retire, so withdrawing from these accounts is not penalized.
Account holders with 401(k) and regular retirement plans face penalties if they make withdrawals before turning 59½, except in times of certain life events or hardships. If you are younger than 59½, and withdraw anyway, there’s a penalty for an early withdrawal.
You can take up to $10K penalty-free if you’re doing it for a first-time home purchase. At least that’s some help. Of course, $10K doesn’t go very far in today’s real estate market!
☛ Definitions: First-time buyers are defined as those who (personally, or their spouses) had no ownership interest in their primary residence for the most recent two years before they close on a home. These people may pull up to $10K from their individual retirement accounts to build, rebuild, or buy a home, as long as they close within 120 days of the withdrawal.
Moreover, the money you take out of your retirement funds will be counted in your income for the tax year. Yes, funds in a 401(k) or a regular individual retirement account get taxed when they’re withdrawn. This means you’ll report the withdrawn funds on IRS Form 1040. Also check out Forms 5329 and 590-B which pertain to the 10% tax penalty on an early distribution of retirement account funds.
Taking retirement funds as income could push you into a higher tax bracket. So, tax time could produce unwanted surprises. Plan carefully. Talk with a tax professional to understand the tax consequences of withdrawing funds from your retirement accounts.
Can I Withdraw Now, and Rebuild the Retirement Account Later?
Yes, you can. Later, after you become a homeowner and have settled into a predictable pattern of income and expenses, you’ll know what you can afford to set aside for retirement. At that point, you could make higher contributions to your retirement account in order to rebuild it.
Do keep in mind the limits on your allowed contributions each year:
- An individual employee can contribute $22,500 to their 401(k) plan in 2023. (As a general rule, an employed person’s recommended savings for retirement should be around 12% to 15%, if possible.)
- In 2023, an account holder can transfer up to $6,500 (or $7,500 after age 50) into an individual retirement account, often called an IRA account.
The amounts shown above are for 2023. These caps change year by year.
According to Vanguard, most people do not meet the generally recommended retirement savings goals. Not even a quarter of Vanguard retirement account holders are saving 10% of their income. Even when we add in the funds some employers contribute for their employees’ plans, the average contribution to retirement is just about 11%.
Is There a Penalty-Free Alternative to Raiding a 401(k)?
If you’re planning ahead, you could consider taking out a 401(k) loan, as opposed to a 401(k) withdrawal. A 401(k) loan is usually issued with no harm to your credit score, and without being held against you as debt when you’re applying for a mortgage. To be sure, ask your mortgage consultant to check with the underwriter of the loan you want to obtain.
Your employer’s plan has to allow 401(k) loans up to $50,000 — or 50% of the funds you have vested in your 401(k), if that would allow you to borrow a higher amount.
The term of the loan is normally five years, but that can be shortened abruptly if you change employers or leave your job. That means the loan becomes due in the same tax year as your job change, or you’ll need to count it as a 401(k) withdrawal — subject to the penalty and tax rules discussed above.
A retirement account with a loan against it might be off-limits to further contributions until you clear the loan. The other downside of getting a 401(k) loan is the interest rate, which is usually just over the prime rate.
The Takeaway?
Yes, you can take money from your retirement account to buy a home. And you’re certainly not alone in doing so. Know the rules, and be sure to consider the potential upside: that is, the way those funds could grow in your new home, in the form of your property’s value.
If you are an employee with a 401(k) account, taking a loan against the account could be a viable alternative for reaching your funds — without depleting them. Still, you’ll pay interest on a 401(k) loan since you’ll be borrowing someone else’s money.
Need specific guidance on what’s best for you? Sit down with a tax pro and have a discussion about your own circumstances and goals. Your mortgage consultant could also tell you about the experiences of other borrowers who have walked this path before you.
Supporting References
U.S. Internal Revenue Service: Taxpayers Should Review the 401(k) and IRA Limit Increases for 2023 (IRS Tax Tip 2022-178, Nov. 21, 2022).
Jeanne Sahadi for Cable News Network (Warner Bros. Discovery), via CNN.com: New Report Flashes a Warning Light Over 401(k) Account Balances (Jun. 15, 2023; citing How America Saves, the annual report from Vanguard).
Kevin Graham for Rocket Companies, Inc. via RocketMortgage.com: IRA Withdrawal for a Home Purchase: What You Need To Know (Jun. 20, 2023).
Written by Gina Freeman and updated by Ryan Tronier for The Mortgage Reports (part of Full Beaker, Inc.): Can You Borrow From Your 401(k) to Buy a House? (May 2, 2023).
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Photo credits: Tima Miroshnichenko and Anna Nekrashevich, via Pexels.