Yes, you are allowed to use funds from your 401(k) plan to purchase a home. It's not the best move, though. There is an opportunity cost to doing so: The funds you take from your retirement account cannot be made up easily.

Let's look at the whys and wherefores of tapping your 401(k) for the joys of homeownership, along with some better alternatives. Throughout, we are going to assume that you are under 59½ years old and still employed.

Key Takeaways

  • You can use 401(k) funds to buy a home, either by taking a loan from the account or by withdrawing money from the account.
  • A 401(k) loan is limited in size and must be repaid with interest, but it doesn't incur income taxes or tax penalties.
  • A 40(k) withdrawal is unlimited and can avoid penalties if classified as a hardship withdrawal, but it will incur income taxes.
  • Withdrawals from IRAs are preferable to taking money from a 401(k).

A Quick Review of the 401(k) Rules

But first, a quick recap of the 401(k) regs. The account is earmarked to save for your retirement: That's why you get tax breaks on it. In return for giving you a deduction on the money you contribute to the plan, and for letting that money grow tax-free, the government severely limits your access to the funds. Not until you turn 59½ are you supposed to withdraw them—or 55, if you've left or lost your job. If neither is the case, and you do take money out, you are dinged with a 10% early withdrawal penalty on the sum you've withdrawn. And, to add insult to injury, you also owe regular income tax on the amount (as you would with any distribution from the account, whatever your age).

Still, it is your money, and you've got a right to it. If you want the funds for a residence, you have basically two options: borrowing from your 401(k) and actually withdrawing from your 401(k).

401(k) Loans

Of the two, borrowing from your 401(k) is the more desirable. When you take out a 401(k) loan, you don't incur the early withdrawal penalty. Nor do you have to pay income tax on the amount you withdraw.

You do have to pay yourself back, though—that is, you have to make repayments to the account. You have to pay yourself interest, too: typically the prime rate plus one or two percentage points. The interest rate and the other repayment terms are usually designated by the 401(k) plan provider/administrator. Generally, the maximum loan term is five years, though a loan taken for the purpose of purchasing the employee’s principal residence may be able to be paid back over a longer period up to 15 years, the IRS states.

Bear in mind that, though they're being invested in your account, these repayments don't count as contributions. So, no tax break for you—no reduction of your taxable income—on these sums. And of course, no employer match on these repayments, either. In fact, your plan provider may not even let you make contributions to the 401(k) at all while you're repaying the loan.

How much can you borrow? Generally, either a sum equal to half your vested account balance or $50,000—whichever is less.

401(k) Withdrawals

Not all plan providers allow 401(k) loans. If they don't—or if you need more than the $50,000 max you're allowed to borrow—then you have to go with an outright withdrawal from the account.

Technically, you're making what's called a hardship withdrawal. Whether buying a new home counts as hardship can be a tricky question, but generally, the IRS allows it if the money is urgently needed for, say, the down payment on a principal residence. But you are likely to incur a 10% penalty on the fund unless you meet very stringent rules for an exemption. You will owe income taxes on them, though.

You're not limited in the amount you can take out, and the withdrawal money doesn't have to be repaid. You can , of course, start replenishing the 401(k) coffers with new contributions deducted from your paycheck.

Drawbacks to Using Your 401(k)

Even if it's do-able, tapping your retirement account for a house is problematic, no matter how you proceed. You're diminishing your retirement savings—not only in terms of the immediate drop in the balance but in their future potential to grow.

For example, if you have $20,000 in your account, and take out $10,000 for the home, that remaining $10,000 could potentially grow to become $54,000 in 25 years with a 7% annualized return. But if you leave $20,000 in your 401(k) instead of using it for your home purchase, that $20,000 could grow to $108,000 in 25 years, earning the same 7% return.

Alternatives to Tapping Your 401(k)

If you must tap into retirement savings, it'd be more advantageous to look at other accounts first—specificallyI RAs—especially if you're purchasing your first home or your first home in a while. Unlike the 401(k), IRAs have special provisions for a first-time homebuyer (whom, by the way, the IRS defines as someone who hasn't owned a primary residence in the last two years).

First, look to take a distribution from your Roth IRA—if you have one. Roth IRA holders are able to withdraw a sum equal to their contributions from their Roth IRA tax-free; in addition, they can withdraw earnings up to $10,000 tax free if the money's for a home.

The next choice would be to take a distribution from your traditional IRA. As a first-time home buyer, you can take a $10,000 distribution without incurring the 10% tax penalty, although that $10,000 would be added to your federal and state income taxes. If you take a distribution larger than $10,000, a 10% penalty would be applied to the additional distribution amount. It also would be added to your income taxes.

The Bottom Line

The best use of 401(k) funds for a home would be to satisfy an immediate
cash need: the earnest money to put into an escrow account, the closing
costs, or, if you're financing the purchase, the money for a 20% down
payment—or whatever amount the lender requires, to avoid having to pay
the additional cost of private mortgage insurance. Bear in mind that
taking a loan from your plan could affect your ability to qualify for a
mortgage; it counts as debt, even though you owe the money to yourself.

However, If you absolutely need to take a distribution from retirement savings, the first account you should target is your Roth IRA, followed by your traditional IRA. If those don't work, then opt for a loan from your 401(k). The option of last resort would be to take a hardship distribution from your 401(k).

Advisor Insight

Dan Stewart, CFA®
Revere Asset Management, Dallas, TX

The short answer is yes, but this is a very complicated issue with a lot of pitfalls. You would only want to do this as a last resort because a distribution from a 401(k) is taxable and there could be early surrender penalties. If your 401(k) allows, you could take a loan out to fund the house and then pay yourself back the interest.

I always tell people to save outside and inside retirement plans. Investors are so concerned with the tax deduction that they put everything they can in their retirement accounts to get the maximum deduction. Like everything else in life, it is about balance.

I would first check to see if your 401(k) offers loans. If not, you may have to research deeper or try to find some type of alternative financing. Using 401(k) money is usually a worst-case scenario.