Can I Use 401(k) to Buy a Home? What to Know About Buying a Second Home After Retirement
Can you use your 401K to buy a house? It's an attractive option to many retirees, and certainly something to consider when buying a second home after retirement. Some retirees may be looking for ski homes where they can hit the slopes or admire the views, while others might want a getaway cottage along the water. Some even want to purchase a second home as an investment property so that they have passive income from rent to supplement their retirement planning. But how does one go about purchasing that second home, especially if they've put many of their financial assets into a retirement account like a 401(k)?
Can I Use My 401(k) to Buy a Home?
The good news is that the money a person puts into a 401(k) belongs to them. The funds can be used for buying a vacation home, but there are different ways to go about it, and there are some pros and cons to each method. Funds can simply be withdrawn from a 401(k), or the owner of the account can borrow money from it. Another option is to use a self-directed IRA to purchase a second home, which comes with a different set of rules. Here are some of the different approaches that can be used to purchase a property from retirement funds.
401(k) Withdrawal for Home Purchase
Making a straight withdrawal from a 401(k) is allowed, similar to how a person would withdraw funds from a savings account. However, this is a very expensive way to purchase a second home. A 401(k) is designed so that people are encouraged to leave the funds in it until they reach age 59. Withdrawing money before that point can incur a penalty on the funds of up to 10%. A 401(k) is funded with pre-tax dollars, so withdrawal will also incur income taxes.
There are some exceptions to this rule, however. If a person has a Roth 401(k), they've already paid taxes on the funds in the account. No income taxes are required for a withdrawal from this type of account. There are also no penalties for this type of withdrawal, so long as a person doesn't withdraw more money than they originally put in. Penalties and income taxes apply if any of the interest earned on the account is removed.
Finally, there are some exceptions to penalties and taxes based on a person's life circumstances. There are very narrow guidelines for this, however. Before searching for homes for sale, a person should talk with their tax preparer or a financial advisor to see if they qualify for any of these exemptions.
Borrowing from 401(k) to Buy a House
Another option that is less costly in terms of penalties and taxes is borrowing 401(k) funds. The money that is taken out needs to be repaid over time, usually over a five-year period. This is essentially like the 401(k) holder issuing a loan to themselves. The money must be paid back with interest at one percentage point more than the prime rate. The money that is borrowed from a 401(k) can be used for anything, including a down payment on a second home.
To withdraw money, the 401(k) holder can take out the lesser of the following:
- $10,000 or 50 percent of the vested balance in the account (whichever is more)
- $50,000
One exception to the five-year payback option is if the funds are going to be used to purchase a principal residence. In this scenario, the person making the withdrawal would have to convert their current home to a rental property or for some other purpose since it cannot remain their principal home.
It's also important to note that while the loan is being repaid, there are no tax breaks. Also, employers won't match the payments. Depending on the entity holding the funds, they may not allow a person to continue making 401(k) contributions at all until the money is repaid.
Using Self-Directed IRA to Buy Rental Properties
A Self-Directed IRA (SDIRA) is also sometimes referred to as a Real Estate IRA. This is a specialized type of investment account that lets the holder invest in alternative assets, including everything from precious metals to real estate. There are some key differences to this type of account to keep in mind.
First, the SDIRA becomes its own entity in the process, much like an LLC. When the account has been funded sufficiently, it can be used to buy almost any type of real estate. It can be used to purchase an existing single-family home, an empty lot for a new construction home, or a condo. In some cases, it can even be used to purchase commercial properties.
Once a property is purchased with these funds, the Self-Directed IRA basically becomes the "owner" of the property. All expenses or income on the property must flow through the SDIRA. This method of purchasing a second home with retirement money is especially popular for rental homes. It's a way of buying a property with rental income paying the mortgage while it appreciates, or providing a passive income stream during retirement.
How to Buy a Home After Retirement
Using the funds from a 401(k) is just one way to pay for a second home after retirement. There are some other methods, and it's also important to keep in mind several additional things. Retirees should consider their wants and needs when it comes to buying another home. They should also think about how to verify their income after retirement and explore mortgage options for retirees. Here's a closer look at all these considerations when it comes to buying a home after retirement.
Consider Your Wants & Needs
People need to think about what type of lifestyle they want in retirement, what their income will be, and any future possible care needs. These things can all factor into the type of property that a person will purchase as a second home. For example, many retirees prefer a single-story home, so they won't have to navigate a flight of stairs as they age. Some want a low-maintenance home in retirement because they plan to travel and may choose to buy a condo. Some may want to live in a retirement community, while others may prefer solitude and quiet.
If a person wants to live in a smaller home in retirement, selling it and downsizing to a second home can be a good option. The sale of an existing home can be a good way to regain back some of the equity while also boosting retirement income. Another option is to keep the first home and use it for rental income, although this may not work with every investor's retirement strategy. One more thing to think about is that it may be easier to qualify for a second home while a person is still working and making a regular income.
How to Verify Income After Retirement
It can be a challenge to verify a person's income after they retire. Much of their wealth tends to be tied up in assets, and they no longer have a W-2 from an employer. It can still be done, however, by proving the following factors to a lender.
- Income: Retirees will still have some income, even if it's lower than in the past. This could include social security payments, monthly dividends, and other forms of income.
- Credit Score: A good credit score obviously never hurts when applying for a loan. The minimum credit score most lenders will consider is 620.
- Debt-to-Income (DTI) Ratio: Lenders will look at what percentage of a person's income goes to servicing debts, including auto loans, credit card debt, and existing mortgage payments. A debt-to-income ratio of less than 45 percent is what lenders prefer.
- Cash Reserves: If a person has a substantial amount of savings, it can factor into a lender's willingness to provide a mortgage loan.
- Equity in a First Home: When someone has equity built up in their first home, it can be used to purchase a second home.
- Assets: Lenders will usually take up to 70 percent of a person's investment assets into account when they consider granting a loan to a retiree.
Mortgage Options for Retirees
There are several different types of mortgages available for seniors, which are designed to suit people in different situations, including:
- Asset Depletion Loan: This type of loan is dependent on how much cash on hand a borrower has. This can be a good option for people who have lost their working salary but who have a sizable amount of cash available.
- Fannie Mae & Freddie Mac Senior Loans: Fannie Mae will consider retirement assets such as a 401(k) when making a loan. Freddie Mac allows borrowers to qualify for a loan if they have substantial investment assets but not a lot of cash on hand.
There are some additional types of loans that a real estate professional can discuss with buyers, but some of those don't directly involve taking out a loan to buy a second home.
A person needs to be at least 62 years old to qualify for a senior loan program. Their existing home needs to be close to paid off, or fully paid off. They also cannot have any delinquent debt on their credit report and must be able to prove that they can cover all of the costs of owning the new home on their retirement income, including property taxes, homeowners association fees, and other expenses.
Buying a Second Home in Retirement is Possible
Purchasing a second home in retirement may not be the right choice for every investor. Fortunately, there are a variety of programs and loans available that an investment advisor or real estate pro can look over with a potential buyer. That dream home might be closer than ever if a person has the right sorts of assets available and is ready to make a move.
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