Seller credit avoids tax hit for homebuyer accessing 401(k)

Withdrawing funds from a traditional 401(k) triggers immediate tax obligations. By having the seller pay the closing costs directly, the buyer avoids both the $10,000 expense and the associated federal tax liability.

Due to age 62, the buyer avoids the 10% early withdrawal penalty, but still owes income tax on the distribution. Assuming a 22% tax bracket, the individual would have needed to withdraw approximately $12,821 to net $10,000 after federal taxes, costing them an additional $2,821 from their retirement savings. Withholding from the 401(k) plan typically results in a 20% prepayment towards taxes, leaving a remaining 2% balance due at tax filing time.

The seller credit eliminates the $2,821 federal tax bill and allows the $12,821 to remain invested, continuing to grow tax-deferred. This also prevents the withdrawal from potentially impacting Social Security benefits, which can become taxable based on provisional income, or increasing Medicare premiums based on modified adjusted gross income (MAGI).

Seller credits are permitted for closing costs and prepaid items like lender fees, title insurance, and property taxes. Loan programs have limits on these credits: conventional loans cap them at 3% with less than 10% down, 6% with 10% down or more, and 9% with 25% or more down; FHA loans allow up to 6% of the sales price; and VA loans permit concessions up to 4% of the appraised value.

Alternatively, the seller could have reduced the home’s price by $10,000. This would lower the monthly mortgage payment by approximately $51 over the life of a 30-year loan, and free up $2,000 for closing costs. However, the seller credit provides more immediate relief.

Homebuyers should request a seller credit equal to their estimated closing costs, staying within program limits. If the credit is less than the total amount needed, they should anticipate needing additional funds from their 401(k) and factor in the associated taxes. It’s crucial to assess the potential impact on Social Security and Medicare before accessing retirement funds.

Fisher Investments offers a free guide, “401k & IRA Tips and Answers,” providing advice on retirement account management and avoiding common pitfalls.