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Home ownership is one of the great American dreams.
But, saving enough to buy your own place is tough.
Ask Heather Chalmers (a pseudonym). She's
thinking about buying a condominium or duplex in Northern Virginia. But, she doesn't know
how she's going to come up with a down payment.
For the past few years, Chalmers has been working to clean
up her credit rating and has been saving every penny she can in her 401(k) plan. As a
result, she doesn't have any extra savings. For that reason, she's thinking of borrowing
from her 401(k) to make a down payment on a residence. She says she can borrow up to
$35,000.
But, Chalmers has a big worry. If she takes this loan,
she'll be tied to her employer for at least another three years while she pays it back.
And, if she leaves her employer earlier than that, she'll have to pay back the outstanding
loan amount at once or it will count as an early withdrawal — then she'll owe taxes
and a penalty on it.
In the meantime, she's getting burned out by the 60-hour
workweeks required by her job. "Here's the part I can't tell my employer — I'm
not interested in working the hours I have worked," she confided.
Still, this concern may not deter her from buying a house.
And, it may not deter many other Americans who plan to tap their 401(k) plans to help them
buy a house either.
One reason folks sign up for a 401(k) is because they can
take the money out early if they need it. A little more than 82 percent of 401(k) plans
offer loans and nearly 89 percent of plans offer hardship withdrawals, says the Profit
Sharing/401(k) Council of America's 43rd Annual Survey of Profit Sharing and 401(k)
Plans. Indeed, participation in 401(k) plans that offer loans is, on average, 6
percent higher than in plans that don't, says the Society of Plan Sponsors. And,
participants tend to contribute about 35 percent more if their plan has a loan option.
If your plan doesn't offer either a loan or a hardship
withdrawal option, all may not be lost. If you have an IRA, the IRS will allow you to make
a one-time withdrawal of $10,000 for the first-time purchase of a home.
Still, you should be aware that borrowing from your 401(k)
plan or taking a hardship withdrawal can set you back considerably in your efforts to
reach your retirement savings goals. Here are some tips from the experts.
Two Strategies
There are two methods of getting money from a 401(k) plan
to use in a home purchase: loans or financial hardship withdrawals.
However, not all plans offer loans or financial hardship
withdrawals. You should read your summary plan description (given to you on the day you
signed up for the plan) to see what options are available to you.
Loans
If you absolutely must take money out of your 401(k) plan
early, the lesser of two evils would be to take a loan, retirement experts say.
The reason is that you are borrowing from yourself and even
as you repay the loan, you can continue to contribute to your 401(k) plan. The best part
about a 401(k) loan is that you don't have to qualify for it. You simply fill out an
application with your human resources department.
But, 401(k) loans do have borrowing limits. You may only
borrow up to half of your 401(k) balance, and the maximum limit is $50,000. For that
reason, you should only expect a 401(k) loan to cover the down payment and you should
expect to borrow the rest from a bank or mortgage company.
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The best part about a 401(k) loan is
that you don't have to qualify for it. You simply fill out an application with your human
resources department.
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Another plus is that your loan repayments are automatically
deducted from your paycheck.
And, most loan interest rates are competitive. According to
the Profit Sharing/401(k) Council of America's 43rd Annual Survey of Profit Sharing and
401(k) Plans, 87.6 percent of plans that offer loans base the interest rate on the
prime lending rate and may add on a percentage point or two. The interest you pay goes
into your account.
That may sound great but there is an opportunity cost,
points out Chris Cumming, vice president of marketing at Diversified Investment Advisors.
The amount you pay in interest will likely be less than that money could earn in the stock
market. And, in the long run, the loss could be noticeable. "You lose that
compounding" at the higher rate, he said.
Typically, most 401(k) loans must be repaid in five years.
However, home loan repayment schedules are longer, commonly 10 years to 15 years, Lee
says.
But, there can be some downsides to borrowing from your
401(k) plan.
First of all, you need to be fairly sure that you will
remain with your current employer for the life of the loan. The reason is that (except in
rare circumstances) when you leave your job, you will need to fully repay the loan. This
was Chalmers' main concern.
Second, you will pay double taxes on the money you repay.
The money deducted from your paycheck to repay your loan comes out after taxes, and you
will again pay taxes on the money when you withdraw it at retirement.
Third, you should expect to pay a fee for the privilege of
borrowing. Most plans charge an origination fee, and a smaller number of plans may charge
an ongoing loan handling fee.
Hardship Withdrawals
If your plan doesn't offer a loan option, you may be able
to take money from the plan using what is known as a financial hardship withdrawal.
This is the greater of two evils, planners say. The reason
is that you have to pay taxes on the amount you withdraw and you will be assessed a
10 percent early withdrawal penalty if you are younger than age 59ý. At a minimum, you
could lose 30 percent of the withdrawal just to taxes. If you withdrew $10,000 to
cover the down payment for a house and you had to pay 30 percent in taxes and penalties,
you'd only be left with $7,000.
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Most plans prohibit participants who
take a hardship withdrawal from contributing for at least one year.
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Further, taking a hardship withdrawal could limit your
ability to contribute again to the plan for the next year. Most plans prohibit
participants who take a hardship withdrawal from contributing for at least one year.
Also, some plans may require you to justify the need to pay
for the house with documentation proving your need for the money.
Ted Benna's Strategy
If you expect to take a hardship withdrawal, Ted Benna,
creator of the first 401(k) plan and president of the 401(k) Association, offers a
strategy to help reduce the tax bite — buy your house early in the year. The reason:
You will have paid nearly a full year's worth of mortgage interest and local real estate
taxes and you can deduct those expenses from your income. Those deductions may be able to
nearly fully offset the taxes and penalty of the withdrawal.
"The point is the earlier in the year you buy, the
better," he said.
Do Your Homework
Before you start shopping for a home, do some planning,
urges Certified Financial Planner Dee Lee, author of Let's Talk Money and The
Complete Idiot's Guide to 401(k) Plans. You should:
- Know what you can afford to pay for the house and also each
month for your mortgage;
- Know where your down payment will be coming from;
- Know what other resources you may be able to tap for money;
and
- Get prequalified for a mortgage so you know how much you can
afford (this can be done in a few minutes).
"Then, you get the ads out," she said.
If the prices are scary, think about trimming back your
expectations (translation: consider a smaller house).
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Before you start shopping for a home,
do some planning. "Then, you get the ads out."
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— Dee Lee,
author of Let's Talk Money and The Complete Idiot's Guide to 401(k) Plans.
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Before tapping your 401(k), try to exhaust all other
financial resources (short of going to the local loan shark). Many banks and mortgage
brokers offer a variety of low- and no-down payment loans. Also, the Federal Housing
Administration offers loan programs tailored to first-time homebuyers and those with
limited resources.
The drawback of some of these loans is that you will be
financing almost the entire home purchase and/or you may have to pay a slightly higher
interest rate — but, you won't have to tap your retirement nest egg.
Additionally, some 401(k) plan providers have relationships
with outside lenders that will offer an uncollateralized loan of up to 100 percent of the
value of your assets in the plan, says Tom Rossi, a consultant with Watson Wyatt
Worldwide. The concept is that lenders outside the plans have figured out that 401(k) plan
participants are a "pretty good credit risk," Rossi said, and on that basis they
are willing to offer an uncollateralized loan. That's a key difference because normally
lenders won't accept 401(k) plan assets as loan collateral.
However, this feature may not be available to all 401(k)
plans. You should check with your benefits department to see if it's available through
your plan.
If none of these options works for you and you decide to
tap your plan, find out how long it will take to get a loan or hardship withdrawal
approved by your employer. You should expect it to take at least a week to get the money;
but, some plans take longer. Knowing this information is critical for when you set a
purchase closing date. |
