In short, no! To deter 401(k) holders from dipping into their retirement funds early, the IRS adds a 10 percent penalty tax to non-qualified withdrawals with additional taxes. Certain candidates may bypass this penalty depending on their age and circumstance.
What are some valid circumstances? Is it worth it to pay the penalty and taxes, using retirement funds to buy a second home? Let’s explore some of the challenges, consequences, and options before using your 401(k) to purchase a second home.
When Am I Eligible to Withdraw From My 401(k) to Invest in Real Estate?
At 59 and a half years old, 401(k) holders may receive qualified distributions from their accounts without penalty. Much like regular income, those qualified distributions can be used to purchase anything you want— including buying a second home or investment property.
Although no penalty is charged when you take a qualified distribution from your 401(k) account, you’ll still need to pay state and federal income taxes for the income received. If you purchase real estate with these funds, income taxes may be reduced for investors of a certain age bracket, like property tax exemptions for seniors. And, you may also be able to take certain tax deductions.
However, keep in mind that you would be investing in real estate with regular income. This means that your investment is not necessarily tax-deferred or tax-free.
Do I Qualify for an Early Distribution?
Early distributions from 401(k)s are set up on a strong-needs basis to provide immediate relief from financial hardship. Suffering a permanent disability permits 401(k) holders who haven’t turned 59 and a half yet to access their savings.
Preventing an underwater mortgage on a primary residence may count as an immediate, strong need for an early distribution. However, buying a second home is not considered an economic hardship to potentially qualify for an early distribution. For 401(k) holders under 59 and a half who are still enrolled in a 401(k) plan sponsored by their company, it's impossible to take out your money to buy a second home, much less without penalties.
If you are experiencing a hardship, you may be eligible to borrow money as a loan from your 401(k). Typically, the repayment includes interest and specified length of repayment terms.
Let’s say you do leave your company and decide to leverage your 401(k) to buy a second home. You should expect to absorb the early withdrawal penalty with the distribution received.
Unless you qualify for a different exception, the early withdrawal penalty is taxed at a rate of 10%. If you were to take out $100,000 from your 401(k) to purchase a second home, the penalty would be $10,000.
What Are Some Other Circumstantial Exemptions?
Leaving your job after you’ve turned 55 is one way you can make withdrawals from your 401(k) without penalties, including buying a second home. Public safety officers and state and federal government workers are eligible to receive distributions beginning at age 50. See IRC Section 72(t).
Keep in mind early distribution penalties are issued based on your withdrawal age at that given time. Withdrawals or distributions are always reported by your plan administrator or custodian to the IRS regardless of your age.
Should I Take the Hit on My 401(k) Now to Set Myself Up to be in a Better Financial Position Later?
Have you maxed out your 401(k) company match contributions and after doing the math realized it still isn’t getting you where you want to go on the financial and retirement planning road ahead? For some 401(k) holders, sucking it up and paying the 10% penalty still has the competitive advantage over leaving their funds to accumulate as they lie in the volatile stock market.
A 10% penalty might seem substantial, but for some individuals, the opportunity cost of a missed investment opportunity is too severe to overlook.
Bear in mind that the rate at which your 401(k) earns is tied to the market that fluctuates based on a 10-year cycle. From age 55 to 64, marking the lower end of the retirement age spectrum, the average 401(k) balance sits at $232,379, while the median sits at $84,714. For many of us, the math adds up to a patterned outcome when it comes to preparing for retirement — not enough.
Let’s assume buying a second home is an investment decision. Leveraging your 401(k) for real estate seed capital can be accomplished in a few ways—know of the rules so you are not penalized for an early distribution.
This is for 401(k) holders who left a former position with a company and rolled their 401(k) from their previous job into the 401(k) with your new position. Technically, the original 401(k) is still separate from the one it is rolled into. Investors who choose to leverage a rollover 401(k) for seed capital will be required to pay the 10% penalty and taxes. However, if you rollover the old 401(k) to a self-directed IRA, you can invest in real estate and not be taxed or penalized the 10%.
Although differently advertised by big banks, investing in real estate with IRA funds is allowed if you have a self-directed IRA. This is very different from using the IRA for a down payment on a second home, or as a first-time home buyer 401(k) loan.
In a self-directed IRA, if the real estate asset you purchased is being utilized as a rental property, then the rental income goes back into the IRA as part of your investment. Following IRS rules and guidelines will help keep your real estate investment in a tax-free or tax-deferred status. Investing in real estate with a self-directed IRA is not considered a distribution unless you break the rules.
It's important to mention, that you can also establish a self-directed Traditional or Roth IRA as a separate retirement plan even if you have an existing 401(k).
There are heavy restrictions for those that want to buy a second home using a 401(k) that make it seem unreasonable. However, an employee may be able to request an in-service distribution. This would allow you to take out a distribution merely for the purpose of pursuing different investment options that you deem more suitable according to your financial planning.
Self-directed Solo 401(k)
With a self-directed 401(k), also known as a solo 401(k), account holders can withdraw their money from the stock market arena and self-direct the investments. There is no penalty for purchasing real estate with a self-directed 401(k).
How Can IRAR Help?
Financial planning isn’t as simple anymore as dumping a small portion of your income into a 401(k) account or an IRA. For nearly 30 years, our dedicated team of self-directed IRA experts have helped clients build wealth through alternative investments like real estate, at a lower cost.
We provide investors of all levels with resources that explain the regulations governing self-directed retirement accounts so they can make an empowered decision to put themselves in the best position financially.
Book a free self-directed IRA consultation with one of our experts today to learn more about how you can leverage a self-directed account to put yourself on the pathway to greater financial freedom.