Can my fiancé use his 401(a) for a down payment on a house instead of cashing it out?
My fiancé is leaving a city job for a government job that offers a pension. At his previous job he had a 401(a). Instead of cashing it out and receiving all the tax penalties, can he roll it over to use it as a down payment on a house instead and not get those penalties? If yes, who and how would we go about this?
Generally, it is possible to rollover a 401(a) to an IRA after early termination of employment. Your fiancé should speak with his HR department about requesting a “direct rollover” to an IRA he can open at any of a number of custodians, e.g. – Schwab, Fidelity, etc. A direct rollover is when the plan trustee distributes an account directly to the trustee, the custodian, of the new account. A direct rollover allows you to avoid withholding 20% of the distribution for Federal income taxes which can occur when attempting an “indirect rollover.”
Once the funds have been transferred from the 401(a) to the IRA, your fiancé will be permitted to withdraw up to $10,000 or the full balance of the account, whichever is greater, to help pay for a first-time home purchase. While this withdrawal will not face the 10% excise penalty levied by the IRS on early distributions, before age 59 ½, the full amount will be subject to ordinary income taxes.
For example if your fiancé is in the 25% Federal Income Tax bracket, a $10,000 withdrawal would generate a $2,500 income tax bill. Additionally, depending on your State of residence, he may face state income tax consequences from the distribution as well. The funds he withdraws from his IRA must be used for “qualified acquisition costs” within 120 days of receiving the distribution. Proof that he used the funds to buy, build or rebuild a home within the time frame may be needed to satisfy questions raised by the IRS about the distribution when he files his 2016 taxes.
I would caution you to think about this distribution critically. Reducing the value of a retirement account, even with a new pension, can have severe long-term consequences. You will be losing the power of tax-deferred compounding, which can be extremely beneficial, for your retirement. It may make more sense, and cents, to delay your home purchase until you have enough funds outside of retirement accounts to make a down payment on your first home.
Ok, let's take this one step at a time. First, an employee does have the right to borrow from the 401(a) plan, but only if the plan/employer allows for the borrowing. If the plan allows for borrowing, the borrowing is limited to the smaller of 50% of the employees vested amount or $50,000, whichever is the smaller. If your fiancé can roll these funds into a another 401(a) or 401-K or 403-B plan with his new employer, then you would look to the plan to find out if borrowing is allowed. If it is, he probably has the same limitations as mentioned above and this will have to be checked with the plan administrator. If on the other hand he takes the 401-A plan and rolls it over to and IRA rollover account, there is no possibility that he can borrow from an IRA. No financial advisor would really like to see these funds taken out and taxed and would prefer that you look to another source of financing for the down payment on a home. I hope this helps and good luck.
401a plans allow employees to save for their retirement. They can be either a supplemental or core retirement plan for employees. Depending on the plan design, employers can require mandatory employee contributions or allow voluntary employee after-tax contributions. I am not certain if the contributions are pre-tax or after-tax. If I assume that the contributions were made on pre-tax basis, your fiance can contact the plan sponsor to initiate a direct rollover to an IRA.
The first step is to open an IRA, so that you can have an account number and custodian to receive the funds on behalf of your fiance. This way your fiance will not have constructive receipt of the funds or receive the funds directly.
The maximum amount that your fiance can withdraw from an IRA free of penalties under the homebuyer exemption is $10,000. You may also be able to withdraw $10,000, thereby doubling this amount.
Remember that the exemption for first-time homebuyer exemption is penalty-free, but not necessarily tax-free.
With a traditional IRA, any dollars that you withdraw will be taxed ordinary income rates. For example, if you’re in the 25 percent tax bracket, if you withdraw $10,000 for a down payment, you’ll only have $7,500.
Because there are several moving parts here, I suggest that you consult with a qualified advisor prior to making any withdrawals. Good luck to you!
First off congrats on being engaged, I'm excited for you both.
Second off- you your fiance can rollover his 401a to an IRA.
Third- You can potentially use $10,000 from the IRA for a first time home purchase. This will avoid the 10% IRS penalty for early withdrawal. BUT it will not avoid the taxation of the withdrawal.
You may want to check out the following posts for newlyweds and home buyers:
Live for Today, Plan for Tomorrow.
-David Rae, CFP