Should I be contributing more to my 401(k) account since I don't have an employer match, or should I put that money towards saving for a home?
I'm 35 years old and I'm currently contributing 10% to my 401(k) with no employer match. I contribute the maximum amount to my IRA account every year. I save $1,000 every month after taxes in an emergency fund. I don't have any debt. My goal is to save enough to purchase a home, but feel like that's a hard goal to achieve. Should I be contributing more to my 401(k) account since I don't have an employer match? Or should I put that money towards saving for a home?
First of all, congrats on being in a stellar financial position. You are doing all the right things by saving into your 401(k), maxing out your IRA, and keeping an emergency fund. 401(k)'s do not have distribution exemptions for a home purchase so if you were to take the funds out of your 401(k) for a down payment, you would have to pay the 10% penalty plus ordinary income tax, so this is not a good option for you. You could take the money out as a loan up to $50k or half the value of the account, whichever is less. The downsides to this are you'd have to pay it back with interest and you'd be forced to make monthly payments back to your 401(k) in the form of payroll deductions. As long as you plan to stay at your current employer long enough and can handle the payments, this can be a solid option for you. If your IRA is a Roth and you've held the account for at least 5 years, you can take out any contributions you made to it tax and penalty-free. You can also take out up to $10k in earnings without penalty or tax as long as it is used for the purchase, repair, or remodel of your first home. If your IRA is a traditional IRA, then you can only withdraw up to $10k for a home purchase without paying any penalty, but you must pay ordinary income tax on the entire amount AND purchase the home within 120 days or you'll be fined the 10% penalty. If none of these options make sense for you, then you may want to consider lowering your contributions to your 401(k), especially considering you don't have an employer match, and instead fund a standard brokerage account with a portfolio suitable to your risk tolerance and the time horizon (how long until it's needed for down payment) for the funds, or simply put it into your savings account. American Express has a high yield, FDIC-insured savings account right now that pays around 1.45% right now (see here), so that could be a good option if you want to go the cash savings route. One thing to note about reducing your 401(k) contributions, be careful about how much you chose to reduce as this could potentially bump you into a higher tax bracket and effectively defeat the entire purpose of the reduced contributions in the first place.
The biggest mistake I see investors make is saving too much in retirement accounts for the tax deduction. Then don't have enough on the outside for alternative investments or a downpayment on a home. You could do a Roth IRA where you can take out any or all contributions for any reason at any time penalty & tax free because you already paid the tax on the contributions. This way it could be a hybrid savings/investing account while a retirement account as well.
Normally, a good rule of thumb is to save 30% to 40% on the outside & 60% to 70% in retirement accounts. This leave you flexible enough to handle "life" as well as retirement. These are just my thoughts without knowing enough of your details like how much you already have saved outside your retirement accounts versus how much you have inside your retirement accounts.
Hope this helps and best of luck, Dan Stewart CFA®
Great job being in your position! That takes dedication and forethought. There is no real incentive for contributing to a 401(k) if there is no employer match. You can still defer taxes with a traditional IRA and typically have access to more or better funds. Based on your income, an even better option would be a Roth IRA so you can enjoy tax-free growth and qualified withdrawals. I recommend also opening individual taxable accounts for your emergency fund and home purchase. You portfolio can be allocated more conservatively based on your goals and time horizon. After you max out your IRA contribution ($5,500 in 2018) and meet your emergency fund and home goals, you could add to the 401(k) as a spillover bucket (max = $18,500 in 2018). However, if you do not need the tax deferral now, you have more flexibility with an individual taxable account that can be more aggressive for building wealth (in addition to the home and emergency fund).
Congratulations on not having any debt and building up your Emergency fund.
how about having your cake and eating it too! Meaning... You can do both by contributing to your 401k and (when you are ready) accessing that money for a home purchase!
There are a few pitfalls with this idea:
- your 401k is volatile and your savings could drop dramatically just at the time you are wanting to access it for your purchase
- You may be best to "borrow" or take a loan from your 401k up to $50,000 or half of your balance. I never encourage you to borrow from your future self, but it is an option.
- you may endure a 10% penalty if it is a non-qualified distribution (hence the loan may be best).
- The equity that you are building may not be that much.
Lets take a deep dive into each of these pitfalls:
#1, if this is a purchase that is going to be made in the next few years, you are best placing your money in a high yield online saving plan. I suggest looking at bankrate.com for programs that are paying over 2% and fully liquid. The reason to avoid putting this money in a 401k is that you want the money easily accessable at the time of your purchase. In addition, the volatile may erode your savings.
#2 If you borrow from your 401k, be mindful of the challenges and the payback process. At the end of the day, you will have to pay back this loan over the next 5/10 years and that will mean less cash flow. Here is a good link that highlights these challenges: https://www.investopedia.com/ask/answers/111815/can-401k-be-used-house-down-payment.asp
#3 The 10% penalty. Even though the distribution will be used towards the purchase of your first home, the first-time homebuyer exception does not apply to distributions from qualified plans like your 401(k)... It applies to IRAs. If you qualify as a first-time home buyer, you can withdraw up to $10,000 from your IRA to use as a down payment (or to help build a home) without having to pay the 10% early withdrawal penalty. However, Uncle Sam wants your money and you'll still have to pay regular income tax on the withdrawal.
#4 Equity. There are several good reasons to buy. The one that tops my list is Pride Of Ownership. Many are convinced that it is a fantastic wealth building tool. Unfortunately, that is not always true. You might find it beneficial to read this blog post from Eric Roberge, CFP® and fee only advisor. Here is an in-depth review of building house equity and how it companies to renting in the big city: https://beyondyourhammock.com/building-house-equity/.
I hope this helps and points you in the right direction.
With love and regards,
Jose Sanchez, CFP®
Good for you for getting a strong start on your finances. This question is a little tough to answer given how little information you’ve given, but hopefully I can provide a little insight. The answer here is contingent on a couple of things: how much you have saved for retirement so far, how far you have to go until retirement, and what the buying/renting situation is where you are living. If you’ve been saving for retirement since your early 20’s and you’ve built a good foundation, it may not be so critical for you to be contributing even more to a 401(k). If you started saving when you are 30, the need to save for retirement may be higher. This is also greatly depends on what portion of your income the IRA contributions are equivalent to. In other words, putting 10% in your 401(k) and maxing out your Roth could mean you are contributing well over 15% of your income or well below 15% of your income to retirement. Also consider how your money can be working harder for you. Since you’re in a lower income bracket and with some of the recent changes in tax law, you may want to consider putting your money into a Roth 401(k) if it’s offered through your employer.
You should also consider the housing market. If you were to purchase a home, can you reasonably save up 20% for a down payment? If you can, that will greatly reduce your fees in the long run. Is it better to buy a home because rent prices are high and a mortgage payment may be lower? Or is the housing market so inflated you aren’t able to accomplish that? Be sure to consider the unexpected expenses that come with buying a home.
I also think it’s interesting you mention that you’re contributing $1000 to an emergency fund per month. Again, this is very much contingent on how much you have saved, but you really only need 3-6 Months of expenses in an emergency fund. If you’re still below that, keep contributing. But if you’ve met that, you could certainly be investing that money somewhere with higher returns (like the market or a house).
In short, it is definitely challenging to save up enough for a home. It’s a goal worth shooting for, but don’t be afraid to take your time in saving up for that down payment. Houses are a large liability and come with a number of unexpected expenses. You’re absolutely on the right track- getting your emergency fund squared away, contributing toward retirement, and setting some thoughtful financial goals. Good luck!