Save a dollar for house downpayment or put it in an individual 401(k)?
I am a self-employed independent contractor. I'm trying to decide what to do with any extra income I earn over the near future, given that I have the eventual goal of purchasing a house (within 2-3 years). I have no current outstanding debts.
In essence, I'm trying to decide whether to save the excess as cash (which would eventually increase my downpayment amount, after tax), or put it into a pre-tax individual 401(k), from which I could draw a 401(k) loan to put toward the house. I realize that 401(k) loans aren't always as attractive an option as they may seem, so I'm trying to get more input on what would net me the most purchasing power toward the house.
For the sake of argument, suppose the 401(k) would be with a custodian that offers low-fee index funds. Because I am self-employed, the "lose your job" drawback of drawing a loan against an employer sponsored 401(k) plan doesn't apply (in other words, I won't face an immediate payback provision). Of course, there is still the risk that I could lose my contract, but I am reasonably confident I could find another gig within a short enough time frame that making the loan payments won't be a concern.
Given that money can go into the 401(k) pre-tax, and that once the loan is paid off, the principal is restored, I'm having a hard time seeing the downside of this approach. Am I missing something or does it actually make sense in my situation?
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Your question boils down to saving for a house or saving for retirement. Why not do both?
If you invest in a Roth 401k or Roth IRA you can withdraw any contributions that are at least 5 years old without penalty (assuming you're willing to put off purchasing a little longer than your original 2-3 years). If you qualify as a first time home buyer (i.e. you haven't owned a home in at least 2 years) you can withdraw investment earnings as well if your distribution is earmarked towards the down payment and is no more than 000.
Although you won't be penalized for using investment earnings for a down payment you will still have to pay taxes on them. So this may be more appealing to someone that has enough contributions to avoid dipping into the investment earnings.
The only other downside is that contributions to a Roth investment are not tax deductible like Traditional IRA and 401k contributions are. Instead, they grow tax free and distributions are tax free when you reach retirement age.
Given that money can go into the 401(k) pre-tax, and that once the
loan is paid off, the principal is restored, I'm having a hard time
seeing the downside of this approach. Am I missing something or does
it actually make sense in my situation?
You're missing several things. Here's a list of what I could think of:
Loans are not always permitted for Solo 401k's. In fact, I think it would be rather difficult to find a provider that would allow that. So you have to verify that it is at all possible.
Loans from 401k come with strings attach. You need to read the plan documents very carefully to know how and when you must repay the loan for it not to be considered a distribution subject to the 10% penalty + tax. Even though you might not have the "termination" provision, there might be some other similar provision specific for self-employed.
Loans cost money. You pay interest on the loan, which means that in this scenario - you're going to pay interest for getting your own money.
You can only get up to 50% of your balance (or 50K, the lesser) from 401k as a loan, at most. The plan may have other (lower) limits, or not allow loans at all.
Banks are not happy when downpayment is based on loan proceeds. I had to sign an affidavit where I state that the downpayment is not from any loan or debt, last time I took a mortgage.
You should make sure that none of these issues is a problem for you.
If it were my money, I wouldn't put it in a 401(k) for this purpose.
If you were working at a company that provided 401(k) matching, then it might be worth it to put the money in your employer's 401(k) because the employer chips in based on what you put in.
But you're self-employed, so there's no matching unless you match it yourself. (Correct?)
So, given that there's no matching, a 401(k) arrangement would have more restrictions than a non-tax-advantaged account (like a bank account, or a taxable money market account). This would be taxable in the year you earn the money, but then that's it.
If you're expecting to pull out the money pre-retirement, I wouldn't put it in in the first place.
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