Brill's Mutual Funds Interactive(R) -- Features

401(k)s and Homebuying

By Clifton Linton
Senior Writer, mPower

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.

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.

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 59½. 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.

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).

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.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.