Should you use a 401(k) to buy a house?

For most people, buying a house will be the biggest expense of their lifetime; even the down payment is the most cash they’ve ever had to come up with. If you are lucky enough to have a robust 401(k) retirement plan, you might be wondering if you tap the funds in it for a home purchase.

The short answer: Yes, you can. After all, the money in your 401(k) is yours, and you can use it as you like. However, your 401(k) probably shouldn’t be your first choice for cash. In most cases, you’ll have to pay a penalty, plus income tax if you take money from your 401(k) early (that is, before age 59½). Even if you manage to avoid these financial bites, you’ll be missing out on years of tax-free, compounded growth of your retirement nest egg.

Nevertheless, in some cases it can make sense to tap your 401(k) to buy a house. To do that, you have essentially two options: borrowing or withdrawing. In this article, we’ll explain both approaches.

Withdrawing 401(k) funds to buy a home

401(k) accounts are designed to provide you with an income in retirement, and there are rules to encourage you to leave the money in the account until you are at least 59½. Normally, if you take funds from your 401(k) before this age, you have to pay a 10 percent penalty on them, as well as income tax. That makes a withdrawal a costly option.

There are two main types of exemption to this rule. The first is if you have a Roth 401(k). With this type of account, you’ve already paid taxes on your contributions, so there are no early withdrawal penalties if you take out the money you’ve paid in. There are penalties and taxes if you take out the money you’ve earned in interest or appreciation, though, and so you should be careful when making this type of withdrawal.

The other exemptions from the standard 401(k) withdrawal rules relate to your life circumstances. You can be granted one of these exemptions if, for example, you have significant medical expenses or are facing foreclosure. Crucially, you can also get an exemption for a down payment or closing costs for a home.

Using your 401(k) for a down payment

You might have read that you can withdraw funds from your 401(k) for a down payment on a first home without any penalties, but that’s not quite true.

The misunderstanding comes from the fact that the IRS rules for 401(k) withdrawals state “costs relating to the purchase of a principal residence” is a type of “hardship withdrawal,” and this type of withdrawal is usually exempt from the 10 percent penalty imposed on an early distribution. This may suggest that, if you’re a first-time homeowner, you can take out funds — in this case, up to $10,000 — from your 401(k) for a down payment on a first home without paying any penalties.

However, though the IRS includes principal-residence costs as a type of hardship withdrawal, in fact it is not exempt from the 10% additional tax when taken from a 401(k). (It is when taken from an IRA — more on that later.)

In other words, you can withdraw the money, but you’ll probably have to pay the penalty. However, you should check with your employer, and the rules they’ve set up for the 401(k). “To be treated as a hardship, the Plan would have to allow it,” says Jim Worthington, an estate and tax attorney who practices in Kentucky and North Carolina. Also, “it must be necessary, which implies there must be no other way to do it” – that is, you have no other assets which could cover the costs.

“Even without the penalty, the funds will be subject to [income] tax, so you have to multiply the withdrawal by your combined federal, state and local marginal rate to determine the actual available funds” you’ll be able to use, he adds.

Borrowing 401(k) funds to buy a home

The second option for accessing your 401(k) funds to buy a house is to take a loan from your plan. Since this is essentially loaning money to yourself, you don’t have to pay the early withdrawal penalty or income tax on the amount you initially withdraw. As long as you pay it back on time, you won’t owe the IRS any extra money for this type of withdrawal.

You can take $10,000 or half your vested amount in the plan (whichever is more), up to a maximum of $50,000. This type of loan is provided by your 401(k) plan provider — double check that they do allow it — and they will set the interest rates for it and the loan term. You should also note that you’ll owe tax on the repayments you make, unlike your original contributions.

Pros and cons of using a 401(k) to buy a home

There are both pros and cons of using your 401(k) to buy a house.

Advantages

• It’s a sure thing: You won’t have to go through a credit check or submit documents to a third-party lender for approval.
• It’s fast: You can liquidate your holdings and get the funds quickly, often within a few days.
• It offers good terms: 401(k) loan interest rates are generally a point or two above the prime rate. Plus, you are paying yourself back, and so after the loan has finished you won’t be any worse off (apart from missing out on interest the account investments would have earned otherwise).

Disadvantages

• If you’re taking an outright distribution, you’ll very likely be charged a 10 percent penalty. You’ll also have to pay income tax on the amount you withdraw, which can be particularly costly for higher-rate taxpayers. Both of these will eat into the amount of money you actually receive.
• Over the longer term, both 401(k) loans and withdrawals can be costly because you are limiting the impact of compound interest on your retirement savings. If you take $10,000 out of your 401(k) now, the account will be worth $54,274 less in 25 years, assuming a 7 percent annual growth rate.
• Even a loan is likely to have significant effects on the eventual value of your account — not just because of lost interest, but because you usually can’t make contributions to the plan during the lifetime of the loan.

Alternatives to using your 401(k) to buy a house

It’s generally worth considering these options before using your 401(k) to buy a home:

• Delay your purchase. If you are able to put off buying a house for a few years, and save up a down payment while continuing to contribute to your 401(k), it’s very likely that you’ll be in a better financial position — both in the short term and in 25 years time (or whenever retirement looms).
• Tap your IRA. Traditional IRAs have special provisions that allow you to withdraw up to $10,000 for a house purchase, and unlike withdrawals from a 401(k), there are no penalties attached. If it’s a Roth IRA, you can of course withdraw any amount of contributions at any time, and — if you’re over 59½ — earnings too.
• Explore low down-payment loans. If you qualify for one of the federal government mortgage programs, such as those run by the Federal Housing Administration (FHA) or the U.S. Department of Veterans Affairs (VA), you won’t need to come up with as much cash: Their loans feature down payments of only 10 or 3.5 percent, vs the 20 percent typically required by commercial lenders. The government-sponsored enterprises Fannie Mae and Freddie Mac also sponsor low-down-payment loans.

Final word on using a 401(k) to buy a home

It seldom makes good financial sense to take money out of your 401(k). The penalties for withdrawals are designed to make it costly to do so, and you’ll miss out on years of interest-free growth on the money you withdraw. If you are buying a house, tapping your 401(k) shouldn’t be one of your first options.

That said, it can be the right move in a limited set of circumstances. If you really can’t wait to buy a house, don’t have an IRA, and don’t qualify for low-cost mortgage programs, you could consider taking a 401(k) loan. Just make sure you are able to pay it back fairly quickly, so you continue to make the most out of your 401(k) plan.