Using a 401(k) to Purchase a Home

One of the more interesting proposals to come out of the current administration over the past year recently just floated down the newswire. While not yet in the form of a bill in congress, the administration has suggested it will push to allow the use of a portion of available 401(k) (and possibly other similar retirement plans) to purchase a personal residence, and potentially otherwise to use the portion of equity purchased with the 401(k) funds as part of the 401(k) itself.

While it’s not yet been passed as law, and we may see some substantial changes on the horizon, it’s a novel proposal. So, let’s take a look at it.

How Using Your 401(k) For Home Purchasing Works Today

If you want to take money out of your 401(k) or another retirement plan to buy a home today, there are a couple of routes.

• You can borrow up to 50% of your 401(k) balance or $50,000, whichever is less, to then use on a home downpayment. This is a loan, so it not only affects your debt-to-income ratio for affordability calculations, but also is a debt that must be paid back with interest. Fortunately, this is to yourself, but the structure as a loan still causes the aforementioned ratio problems.
• If you are purchasing or building your first home, you can distribute up to $10,000 from a pre-tax IRA penalty-free, although the distribution is still taxable, meaning that your net of tax distribution might be closer to $7,000 or so when the taxes are accounted for.
• If you have a Roth IRA and meet all of the requirements (minimum holding period being the key here), you can distribute principal from the Roth IRA penalty-free in order to help make your home downpayment.
• Perhaps most catastrophically, if you’re faced with the potential loss of your home (for which let’s say your current home is a rental that you rent and the owner wants to sell), you can take a “hardship distribution” from your 401(k), which will let you distribute up the same loan balances described above, but with full income tax and early distribution penalties, which obviously makes it rather expensive.

As you can see, none of these mechanisms is particularly homebuyer-friendly. While they all ostensibly provide you with access to capital that would otherwise be locked up until retirement, they all come with the downsides of impacting your financing, costing a lot in taxes, or at the very least, robbing Peter (your retirement) to pay Paul (your home lender.)

The 401(k) Home Purchase Proposal

The idea, as it has been described by the administration, is an interesting one. Rather than permitting the taxable or penalty-free distribution of money from your 401(k), it’s to loosen the prohibited transaction and custody rules around your 401(k) slightly to let you “invest” in your home. And if that phrase doesn’t make any sense to you, let’s explain.

Retirement plans have several legal mechanisms that ensure they operate correctly and in compliance with federal law, to which most states conform with some limited exceptions. One of them is a custodial rule, which generally can be summed up as: “If you touch it, you broke it.” This rule is easy to follow in most retirement accounts, which are held in trust by qualified custodial firms such as Charles Schwab and Fidelity. The money is at the institution, rather than in your individual possession, so you can’t touch it, and therefore, it enjoys its tax-deferred and tax-advantaged status for so long as you don’t touch it. Then, one day, when you distribute it, it becomes subject to the applicable taxes.

This rule is a bit more obvious in the mechanism of something called a “self-directed IRA,” which permits the investment of retirement funds into more tangible assets such as rental properties or collectibles. However, the rule about not touching the assets can be quite literal. So much as going into your rental to use the restroom can result in a disqualification of the rental property’s tax advantaged status, rendering a rental property in such a situation suddenly a taxable asset subject to both income taxes and even early distribution penalties. Similar issues have occurred for those investing in things like art, because the art was hung in their home rather than kept at a qualified storage facility, and thus, the personal use rendered the art taxable and penalizable. Yikes.

So, the proposal to allow 401(k) plans to “invest” in a primary residence for you is an interesting one, because it not only circumvents all of the aforementioned issues of taxation, loans, and potential penalties, but also circumvents the prohibition against personal use of your retirement funds prior to retirement.

The Mechanisms Involved

So, let’s take the example case the administration has floated. You want to buy a $500,000 home and happen to have $50,000 in your 401(k) plan. As we understand it, you could make a 10% downpayment on the property through your 401(k) (possibly less, depending on what limitations or caps they put in place as part of the proposal). Your 401(k) would then be a part owner of the property. As you then proceeded to make mortgage payments on the remaining borrowed 90% debt, you would steadily become an equity owner in the property outside of the 401(k). Let’s say 30 years down the road, your home is now worth $1,000,000 and the mortgage is paid off. At that time, your 401(k) home equity balance would also have grown twice as large to $100,000, and you’d have $900,000 of genuine home equity.

This is a reasonably exciting proposal at face value. Not only would it make it more affordable for people to save for their first home by receiving and using matching funds from their employer’s retirement plan, but it would also solve a lot of the aforementioned loan and interest provisions. So where could it go wrong?

Three potential problems come to mind.

First, a similar paradigm exists in the form of ROBS 401(k) retirement plans, in which a 401(k) is used to finance the startup of a business or the purchase of a franchise. While ostensibly a useful means to access capital to pursue entrepreneurship and the American dream, ROBS plans are plagued by substantial compliance costs (both in time and money), and are regularly so burdensome that they often drag substantially on the long term financial returns of the investor’s retirement plan. Further, the compliance can be problematic from the standpoint of just the everyday operations of the business and working in the business!

Second, the proposal has not been particularly clear about the “what if it goes wrong” outcomes. What if the home is foreclosed on? What if the owner is divorced? Can such a property be jointly owned by spouses or, like all other retirement plans, is the plan fundamentally individually owned and thus the 401(k) balance is also individually owned? Can both spouses invest in the 401(k)-to-home-purchase program? What about cost basis and the allocation of expenses?

Third, the most likely candidate to use a program like this is a young individual or couple. While home equity is a bedrock of much of the American wealth-building exercise, primary residences seldom show enormous or substantial rates of return. Consequently, borrowing some of your earliest retirement savings, those dollars that have the highest likelihood of appreciating and compounding to a substantial balance to invest in a lower-returning asset like a primary residence, may have a substantial and deleterious effect on a homeowner’s long-term wealth building.

None of these problems is to say that the idea shouldn’t be fully fleshed out and explored, but like all things, there is no free lunch. And as a financial planner, I’ll admit that I’d rather have a tool and not use it and not have the option! We’ll be rather curious to see where the administration takes this proposal (if anywhere), and what a final rule might look like in practice. For now, it is the stuff of interesting hypotheticals.