Think Twice Before Taking Money Out of Your 401(k)

I see this all the time. A buyer finds the house they want, and now they need money for the down payment. Maybe they have some money saved, but they also have a good amount sitting in their 401(k).
Then comes the question, "Should I take money out of my 401(k) to buy the house?" And sometimes buyers go one step further with "Why don’t I take even more out, put a bigger down payment down, and lower my mortgage payment?" I understand the thinking, but this is where I want buyers to slow down and really look at the numbers.

If you have the choice between withdrawing money permanently from your 401(k) and borrowing from your 401(k), I generally prefer looking at the loan option first. Why? Because there is a huge difference between borrowing your retirement money and putting it back versus taking your retirement money out and never giving it the opportunity to grow again.

First, How Does a 401(k) Loan Work?
Not every 401(k) plan allows loans, so you have to check with your employer or plan administrator. Under current IRS rules, a plan that permits loans will generally allow you to borrow up to the lesser of $50,000, or 50% of your vested 401(k) balance.
There are some additional rules and exceptions, so buyers need to verify the exact amount available through their individual plan. Normally, a 401(k) loan has to be paid back within five years. However, the IRS allows an exception to the five-year rule when the loan is being used to purchase your primary residence, although the actual repayment period your plan offers will depend on the plan itself.

Here is something a lot of buyers don’t realize. The interest you pay on the 401(k) loan generally goes back into your own 401(k) account. Your employer’s plan determines the actual interest rate. A common structure is around Prime Rate + 1%. Fidelity, for example, describes Prime + 1% as a typical rate. The Federal Reserve reported the bank prime rate at 6.75%. That would put an illustrative Prime + 1% 401(k) loan at approximately 7.75% today. That doesn’t mean every plan is charging 7.75%. Your plan sets the actual rate. But remember the important part. Much of that interest is being paid back into your own retirement account, not to a mortgage company, bank, or credit card company.

What Happens If You Just Withdraw the Money?
This is where things can get expensive. If you’re younger than 59½ and simply take a taxable early distribution from a traditional 401(k), the money is generally included in your taxable income and may also be subject to a 10% federal early-distribution tax, unless you qualify for an exception.

Here’s another important point that many buyers don’t know. The IRS has a first-time-homebuyer exception of up to $10,000 for certain IRA distributions, but that particular exception does not apply to qualified plans such as a 401(k). So don’t automatically assume! "I’m buying my first home, so there won’t be a penalty." That may not be true with a 401(k). And if you’re in California, there can be another issue. California generally imposes an additional 2.5% early-distribution tax on an early retirement distribution unless an exception applies, in addition to normal California income taxes. This is why I always tell buyers to speak with their CPA or tax advisor before making a withdrawal.

Let’s Put Real Numbers to It
Let’s say two buyers are each purchasing an $800,000 home, and both want to put 5% down = $40,000. Now let’s compare two different buyers:
Buyer #1: Borrows $40,000 From the 401(k). The buyer takes a $40,000 401(k) loan.
For illustration, let’s assume – $40,000 loan – 7.75% interest – 5-year repayment period
The payment would be approximately $806 per month. That payment is certainly something we need to consider in the buyer’s monthly budget. But the major difference is that the buyer is putting the money back into the retirement account, including interest. There is still an opportunity cost because the borrowed money is temporarily out of the investments and may miss market growth. That’s one of the biggest disadvantages of a 401(k) loan. But the money isn’t simply gone forever. 

Buyer #2: Withdraws $40,000 From the 401(k) – Now let’s say Buyer #2 simply takes a $40,000 taxable early withdrawal. For illustration only, let’s assume this buyer is in a 22% federal income-tax bracket and owes the 10% early-withdrawal tax. That’s potentially $8,800 federal income tax plus $4,000 early-withdrawal tax for a total potential federal cost of $12,800.
That could leave the buyer with only about $27,200 from the original $40,000, before considering state income taxes or any other applicable taxes or plan charges, and for a California buyer, there may also be the additional 2.5% California early-distribution tax, plus ordinary California income tax. That means somebody who says, "I need $40,000, so I’ll withdraw $40,000" may be in for a big surprise. Using our simplified 22% federal bracket plus 10% federal early-withdrawal tax assumption, someone trying to actually end up with $40,000 after those federal costs could theoretically need to withdraw approximately $58,824. And that still doesn’t account for state income taxes or the possibility that the additional income pushes part of the distribution into a different tax bracket. 

Now Here Is the Number That Really Gets My Attention
Let’s forget about the taxes for a minute and just look at the money that was removed from retirement. What could that original $40,000 have become if it stayed invested? Let’s assume an average hypothetical return of 8% per year for the next 25 years. That $40,000 would grow to approximately $273,939. That’s almost $274,000. So, when someone tells me, "It’s only $40,000 out of my 401(k)." I don’t look at it as only $40,000, I look at what that $40,000 potentially represents 20, 25 or 30 years from now. At our hypothetical 8% return, you’re removing the original $40,000. You’re potentially giving up another $233,939 of future growth over 25 years. Of course, an 8% return is only an assumption. Markets don’t deliver the same return every year, and future investment performance is never guaranteed, but the example demonstrates the power of compounding. 

Which One Would I Rather See a Buyer Do?
My first choice is always to look at the entire financial picture before touching retirement money at all. Maybe we don’t need the bigger down payment. Maybe keeping more money invested makes more sense. Maybe having cash reserves after closing is more important than trying to get the mortgage payment as low as possible.
But if the decision comes down to:
"Do I permanently withdraw $40,000 from my 401(k), or do I borrow $40,000 from it and repay myself?"
I would generally rather investigate the 401(k) loan.  With the loan, you avoid creating an immediate taxable distribution as long as the loan follows the rules. You avoid the normal 10% early-distribution tax associated with a taxable early withdrawal. You are putting the principal back. The interest generally goes back into your retirement account. But there are still risks. The borrowed money isn’t invested while it’s out of the account, so you can miss market growth. Your paycheck will also be smaller while you’re making the loan payments. And if you leave your employer or fail to repay the loan properly, the unpaid balance can potentially become a taxable distribution.
That’s why this isn’t a decision buyers should make by simply saying "A bigger down payment means a smaller mortgage, so it must be better." It isn’t always better. 

Don’t Sacrifice Your Retirement Just to Lower Your Mortgage Payment
This is the conversation I want more homebuyers to have. Your mortgage is one part of your financial life. Your 401(k) is another. Reducing your mortgage payment by a few hundred dollars a month might feel great today but permanently removing money that could potentially compound for another 20 or 30 years can have a much bigger long-term cost than most buyers realize. Sometimes using 401(k) money can absolutely be the tool that helps someone become a homeowner. I just want buyers to use that tool intelligently.
Before you withdraw retirement money, find out whether your plan allows you to borrow against it instead. Then have your mortgage professional, financial advisor, and tax professional help you look at the entire picture, not just the mortgage payment. Because buying the house is important, but so is making sure you still have money when you’re ready to retire. 

Interest Rates
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Condo Update 

Good news:

• Arroyo West is off the naughty list! YAY!    

Bad news:

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Also: 

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