Prudent savings and investment open many doors for those who steward their money wisely. Making a nestegg a priority can, over the years, make that modest provision for the future into a formidable financial corpus. Of course, there is retirement to consider and plan for. Yet there are necessities for the here and now that likewise need attention.
One such need is shelter. When adequate monies are reserved for a house, does it not make sense to use them? That question is answered by evaluating how much is saved and for what purpose. The 401(k) is an excellent example.
The 401(k): A Brief History
While 401(k) accounts are ubiquitous today, they are only four decades old. In 1978, the U.S. Congress passed legislation that protected certain savings, particularly that set aside for later use, from taxation. This was codified into the Internal Revenue Code, Section 401(k).
Out of this protection grew the idea of reserving pre-tax dollars in a retirement plan whereby employers would match the amount put aside by employees. Subsequently, in 1981, the IRS allowed for this retirement fund to be fed through payroll deductions, making such financial accumulation easy and convenient. From then on, 401(k) plans proliferated.
How Does a 401(k) Plan Work?
To begin, there are actually two distinct 401(k) methods of saving: Traditional and Roth. Under the traditional scenario, as you contribute to the fund and it grows untouched, that money is not subject to taxation. The benefit is that your taxable income, upon which your annual IRS obligation is based, is reduced by that much. Until you begin withdrawing funds in retirement, the savings are tax free. Under the Roth regime, the employee contributes money that had already been counted as taxable income. Where is the benefit there? Like the traditional plan, the money grows tax-free. Unlike the traditional design, there is no tax to be paid upon withdrawal.
Can I Access Funds from My 401(k) Before I Retire?
Two realities apply here. First, it’s your money: you earned it and saved it. The second truth is that the government refrains from placing levies on the money as long as these savings are deferred. How do these play out?
Typically, those who withdraw funds from a 401(k) prior to attaining the age of 59.5-years old are subject to a penalty of 10 percent of what is taken out. On top of the tax you will now have to pay, that is a big hit. Exceptions are made generally in cases of adversity like unforeseen disability or onerous medical expenses.
Still, there is an alternative to premature withdrawal. Many 401(k) plans allow for borrowing against the value of the fund. There are strings attached, of course: borrowers usually have no more than a few years to repay the loan. After that, the loan converts to withdrawal, with all the tax and penalties that come with it. Another disadvantage is that the loan removes money upon which interest would accrue.
Moreover, borrowers must pay interest as with any loan. Worse, layoff or termination from employment may require that the loan be paid within months, not years. One more thing, as you repay this loan, those remittances do not count as new contributions so they do not reduce the taxable income. Plus, employers do not match re-payments.
As grim as those drawbacks sound, taking out a 401(k) loan to purchase a primary residence may allow a borrower more time to pay it back. Most plans allow loans of up to one-half the vested account balance or $50,000, whichever amount is smaller. This can serve to begin ownership with higher equity in the property. Remember, it’s always wise to consider the tradeoffs of paying off your home sooner or investing more.
Loans that Can Spare the Use of 401(k) Funds
Taking money from a 401(k) fund for a down payment may, in many cases, be unnecessary.If you are a veteran of the armed services, the U.S. Department of Veterans Affairs guarantees loans that offer full financing without any cash due from the borrower other than closing costs.
If you are house shopping in rural areas, the U.S. Department of Agriculture does the same. Even the U.S. Department of Housing and Urban Development sponsors loans that require a mere $100 down.
Other loan programs through FannieMae, Freddie Mac or the Federal Housing Administration back mortgage loans with substantially lower down payment mandates than the standard 20 percent. Of course, there is always a price.
Other than VA loans, most of these agency-backed mortgage products, available through private sector lenders, require some form of mortgage insurance. The premiums are most often paid monthly along with the mortgage principal, interest and escrows.
The total premium works out to a fixed percentage of the loan amount, determined by credit score and how much equity the borrower has. While this adds to the monthly cash outflow, at least borrowers do not have to tap retirement accounts.
Using Funds from an Individual Retirement Account (IRA)
Like 401(k)s, IRAs come in traditional and Roth (tax deferred vs. tax now) versions. For first-time home buyers, this is a flexible definition. You can not have owned a home for at least two years and $10,000 is eligible to be withdrawn without penalty if the property is a primary residence. There is no penalty under those parameters.
How Do Underwriters Evaluate Down Payments
A purchaser can bring 20 percent of the sales price for a down payment, but that is not the end of the matter. Where those monies come from is important, too. Clearly, if you borrow money to make a down payment, that must count toward your total debt obligation.
Yet money borrowed from a 401(k) does not, because it is your money. At the same time, math is math, and funds taken out of the retirement account for down payment means fewer funds to count toward overall assets.
A Survey of Retirement Savings
In February of 2020, the Colorado Sun reported that 40 percent of Rocky Mountain State residents had no designated retirement fund. Whether funds earmarked for later years are sitting in other types of accounts is unknown.
Oregon, on the other hand, offers the OregonSaves program to workers who receive no retirement benefit from their employers. Similarly, Washington launched the Retirement Marketplace initiative in 2018 to help small businesses find affordable plans for their employees.
Although many may purchase a retirement plan individually, over half of Idaho’s labor force do not receive the benefit through the workplace. These states have an interest in helping people save for less productive years.
Consult a Mortgage Professional before Deciding
Prior to withdrawing 401(k) funds to help with a home purchase, talk to an experienced loan officer about the underwriting process. As described above, the funds removed can work for and against your application, all other variables being equal.
This representative can also advise you about the loan products that might allow you to avoid touching your retirement savings in order to buy a house. While a loan officer is not a financial planner or advisor, this person has an interest in making certain that prospective customers are in a financially sound position when they obtain a loan.
Since 1992, Sammamish Mortgage has offered high quality mortgage loan programs in Washington, Oregon, Idaho, and Colorado.
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