Wednesday, July 17, 2019
DON'T DO IT!
Many first-time home-buyers take a distribution from their company’s 401(k) retirement plan to help fund the down payment for the purchase of the home. And, unfortunately, they tell their tax professional about it AFTER it has been done.
This is a bad idea. The distribution is included in the federal and probably also state taxable income of the taxpayer – at a cost of 25% to perhaps as much as 40% of the distribution. In addition, if the taxpayer is under age 59½ he or she must pay an additional 10% penalty for early withdrawal – bringing the cost of the distribution up to as much as 50%. So, a distribution of $20,000 only puts $10,000 to $13,000 in the taxpayer’s pocket.
The overall tax and other financial benefits of home ownership may eventually outweigh the tax cost of a 401(k) withdrawal, but I still say this is still not a good idea.
If there is no other source of funds for the down payment consider taking a loan from the 401(k) plan, if allowable, instead of an outright distribution. The interest rate on 401(k) loans is usually low, and you are actually probably paying the interest to yourself. This loan must eventually be paid back, or the outstanding balance will be treated as a distribution when employment with the company ends. FYI, the interest charged on the 401(k) loan is NOT deductible on Schedule A.
One way to avoid the 10% premature withdrawal penalty when a loan from the plan is not an option is to rollover a 401(k) distribution of up to $10,000 into an IRA account and then take a $10,000 distribution from the IRA account. Or just take $10,000 from an existing IRA account instead of the 401(k) plan. One of the exceptions to the 10% penalty for premature withdrawals from an IRA account is a distribution for first-time purchases. A purchase qualifies as “first time” if the taxpayer did not own a home in the two years prior to the withdrawal. This exception DOES NOT apply to premature withdrawals from a qualified plan such as a 401(k).
So, if you are thinking about buying a home your 401(k) plan should be the last place you turn to for funding the down payment. And you should discuss it with your tax professional BEFORE you do anything.