401(k) for a Downpayment: Is it Ever a Good Idea?
The 401(k) is one of the most important retirement programs available to the American worker.
As a bedrock for retirement savings, this plan allows employees and employers to make pre-tax contributions to an investment portfolio, allowing you and your employer can invest money that you have not paid taxes on. (Basically, if you earn a $1, you can invest it all and pay taxes later, instead of giving $.25 to the government and then investing $.75)
Taxes are paid when you make withdrawals upon retirement. When combined with employee contributions, this delayed tax option creates significant opportunities for financial growth.
The program is intended to create comfortable retirements. But in some cases, people have hundreds of thousands of dollars (or millions) in their 401(k) and need access to that money right away.
There can be a wide range of situations when someone might want to take money out of their 401(k) before retirement, but as we’ll see, this should only be done in special circumstances…
Using a 401(k) for a Downpayment
401(k) Withdrawal vs Loan
Essentially, there are two ways that you can take money out of your 401(k) before retirement. First, you can make a simple withdrawal. Unfortunately, this is one of the worst ways to access your money. When you make an early withdrawal from your 401(k), you will pay significant taxes; not only will you have to pay your standard income tax rate, you’ll also have to pay a 10% penalty on the withdrawal. If your tax rate is 25%, for example, you’ll pay 35% of the withdrawal in taxes. So if you withdraw $10,000 from your 401(k) before retirement, you’ll pay roughly $3,500 to the government and only pocket $6,500!
A better way to use your retirement savings, although still not ideal, is a 401(k) loan. Rather than simply withdrawing the money, you actually take out a loan against the account and make a promise to pay it back. A 401(k) loan is often repaid through payroll deductions, with payment timeframes as long as five years, and payments made on a monthly basis. To ensure the money is repaid, some programs won’t allow you to contribute until the loan is restored. (Besides, you’re basically repaying money into the account, so whether you are “contributing” or “repaying,” it’s essentially the same sum in the end.)
In general, loans are better than straight withdrawals, although there are still financial penalties plus the loss of any generated growth that the money, if left in the account, would have gained.
However, there may be reasons for using a 401(k) for a downpayment.
Top Reason for Taking Out Money: Avoiding Mortgage Insurance
There is little doubt, if you have the money on hand, the best way to fund a down payment is basic savings from your bank account. However, if you have little money in readily-available savings but a large sum in your 401(k), it could make sense to use your retirement funds for a downpayment if it can help you avoid mortgage insurance.
Mortgage insurance is essentially an extra amount of money added to your mortgage bill that you pay until you reach a certain level of equity, usually 20%. When you use a 401(k) for a downpayment, it may be possible to avoid mortgage insurance. Essentially, you could borrow money from your 401(k) to reduce your mortgage payments for the initial period.
Again, this is not a simple equation, so you need to be completely sure of the numbers to justify this use of 401(k) dollars. It can be complex, but you’ll have to basically compare the total cost of mortgage insurance and the total cost of a 401(k) loan.
Once again, speak with a trusted expert before making any decision.
The Downside of Using 401(k) for a Down Payment
As you may have noticed, we are very cautious about recommending the use of a 401(k) for a downpayment, even if it’s a loan. We’d like to elaborate a little more on why.
Outside of the fees and taxes, there is also the loss of future growth. When money is sitting in your 401(k), it’s gaining interest in the open market (assuming steady growth, of course) and increasing your retirement funds. When it’s out, you don’t just reduce the amount that currently sits in your 401(k), you loose out on any growth that money could accumulate. While the stock market can certainly go down from time to time, conventional investing wisdom tells us that if you leave money in the stock market for an extended period, it will, over the long term, go up.
Taking money out also creates a limit on your full contributions. Because money in a 410(k) is protected from taxes, the government has created a limit on how much you can contribute. If you have outstanding balances on your account, you’ll likely be prevented from making full contributions. This also means that you’ll miss out on employee matching. Depending on the length of your loan, you could essentially loose out on five years worth tax-delayed retirement investing.
Another important factor, and one that probably doesn’t get discussed enough in personal finances, is unforeseen circumstances. All plans, financial or otherwise, work out perfectly when things go as planned. But life happens and the best laid plans can be disrupted. For example, if you borrow from your 401(k) and then leave your job (by choice or otherwise), you will have roughly 60 days to repay the entire balance of your 401(k) loan. If you can’t pay, the remaining balance is treated as a taxable withdrawal and subjected to the 10% tax hit!
Keep it as a Last Resort
In case you haven’t noticed, we’ll say is plainly: only use a 401(k) for a downpayment as a last resort. Be sure that you have looked over all other alternatives to using the retirements funds before taking out a 401(k) loan or withdrawal, and always talk with a trusted advisor before making any major financial decisions.
Get Common-Sense Advice on Your Mortgage Options
When you are ready to learn more about mortgage options, contact the team at San Diego Purchase Loans. We’ll help you find the right program to fit your needs and budget while explaining the benefits and drawbacks for each strategy and program.
From jumbo loans to assistance with USDA or VA loans, we are here to guide you through the entire process.