If you're short on cash for a down payment, and you happen to have a retirement plan at work, you might be wondering if you can use a 401(k) to buy a house. The short answer is yes—you can withdraw from your 401(k) for a house. However, a 401(k) withdrawal for a home purchase is generally not the best move, given there is an opportunity cost in doing so. Here's a look at tapping your 401(k) for homeownership, along with some better alternatives. (This article assumes that you are less than 59½ years old and still employed).
- You can use 401(k) funds to buy a house, either by taking a loan from the account or by withdrawing money from the account.
- While a 401(k) withdrawal is technically unlimited, it is generally limited to the amount of the contributions you made to the account and can avoid penalties if it is classified as a hardship withdrawal, but it will incur income taxes.
- Withdrawals from Roth IRAs, and some other IRAs, are generally preferable to taking money from a 401(k).
- A 401(k) loan is limited in size and must be repaid (with interest), but it does not incur income taxes or tax penalties.
- You can withdraw contributions from a Roth 401(k) tax- and penalty-free.
A 401(k) plan is earmarked to save for retirement—that's why account holders get the tax breaks. In return for a tax deduction on the money contributed and for letting that money grow tax-free, the government severely limits access to the funds.
The earliest you can withdraw 401(k) is 59½ years old—or age 55, if you've left or lost your job. If neither is the case, and you do take money out, you incur a 10% early withdrawal penalty. To add insult to injury, accountholders also owe income tax on the amount.
Still, it is your money, and you've got a right to it. If you want to use the funds to buy a house, you have two options: borrow from your 401(k) or withdraw the money from your 401(k). Loans and withdrawals are not just limited to home purchases (i.e. the downpayment for a home), but can be used for second homes, home improvements, or to build a house.
Option 1: 401(k) Loans
The first option for using a 401(k) to purchase a home is borrowing from your 401(k)—this the more desirable option. When you take out a 401(k) loan, you do not incur the early withdrawal penalty, nor do you have to pay income tax on the amount you withdraw.
But you do have to pay yourself back—that is, you have to put the money back into the account and will pay yourself interest. The interest rate and the other repayment terms are usually designated by your 401(k) plan provider or administrator. Generally, the maximum loan term is five years. However, if you take a loan to buy a principal residence, you may be able to pay it back over a longer period than five years.
Bear in mind that although the loan payments are being invested in your 401(k), these repayments don't count as contributions (so no tax breaks) and there is no employer match for those. 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 from your 401(k)? Generally, either a sum equal to half your vested account balance or $50,000—whichever is less.
Option 2: 401(k) Withdrawals
Not all plan providers allow 401(k) loans. If they don't—or if you need more than the $50,000 loan max—then you have to go with an outright withdrawal from the account. You are likely to incur a 10% penalty on the amount you withdraw unless you meet very stringent rules for an exemption. Even then, you will still owe income taxes on the amount of the withdrawal.
You're only limited to the amount necessary to satisfy your financial need, and the withdrawn money does not have to be repaid. You can, of course, start replenishing the 401(k) coffers with new contributions deducted from your paycheck.
Why You Shouldn't Use Your 401(k) to Buy a House
Even if it's doable, tapping your retirement account for a house is problematic, no matter how you proceed. You diminish your retirement savings—not only in terms of the immediate drop in the balance but in its future potential for growth.
For example, if you have $20,000 in your account and take out $10,000 for a home, that remaining $10,000 could potentially grow to $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 a home purchase, that $20,000 could grow to $108,000 in 25 years, earning the same 7% return.
Note that a Roth 401(k) allows you to withdraw the money you've contributed at any time tax- and penalty-free.
Alternatives to Using Your 401(k) for a Home
If you must tap into retirement savings, it's better to look at your other accounts first—specifically individual retirement accounts (IRAs)—especially if you're buying a first home (or your first home in a while).
Unlike 401(k)s, IRAs have special provisions for first-time homebuyers—people who haven't owned a primary residence in the last two years, according to the IRS.
First, look to take a distribution from your IRA—if you have one. You may be able to withdraw IRA contributions without penalty due to a qualified financial hardship. You can also withdraw up to $10,000 of earnings tax-free if the money is used for a first-time home purchase.
As a first-time homebuyer, you can take a $10,000 distribution without paying the 10% withdrawal 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.
Another option is to use a Roth 401(k), if you have one. Withdrawing contributions that you made to a Roth 401(k) can be made tax-free and penalty-free. Note that if you withdraw more than the total of your contributions (i.e. you tap into the earnings), that will be taxed and hit with an early withdrawal penalty.
There are special homeownership programs offered by the federal government to encourage homeownership. This includes Federal Housing Administration (FHA) and Veterans Affairs (VA) loans. These programs offer lower down payments and have less stringent credit requirements.
Notably, FHA loans have a minimum down payment of 3.5%, which may help prospective buyers avoid having to take a 401(k) loan or withdrawal to come up with a sizable downpayment. Meanwhile, conventional loans may require up to 20% down.
Can You Use a 401(k) to Buy a House?
The short answer is yes, since it is your money. While there are no restrictions against using the funds in your account for anything you want, withdrawing funds from a 401(k) before the age of 59 1/2 will incur a 10% early withdrawal penalty, as well as taxes. So, while it is possible to tap your 401(k) in lieu of a mortgage loan it would end up being a very expensive source of funds, not to mention being very disruptive to your retirement savings.
What Reasons Can You Withdraw From a 401(k) Without Penalty?
There are select reasons that you can withdraw money from a 401(k) without paying a penalty—including medical debt that exceeds a percentage of your adjusted gross income, a permanent disability, being called to active military duty, or court-ordered withdrawal to pay a former spouse or dependent.
How Much Can You Take Out of Your 401K to Buy a House Without Penalty?
Any withdrawal from a 401(k) for a home purchase will incur an early withdrawal penalty.
How Much Can You Take Out of Your IRA to Buy a Home?
IRA withdrawals for first-time homebuyers (or individuals that have not owed a home for at least two years) are allowed for up to $10,000.
Can I Withdraw Money From My 401K to Buy a Second House?
Yes, but you will incur an early withdrawal penalty, as well as taxes.
The Bottom Line
The best use of 401(k) funds for a home would be to satisfy an immediate cash need (e.g., earnest money for an escrow account, down payment, closing costs, or whatever amount the lender requires to avoid paying for 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 need to take a distribution from retirement savings, the first account you should target is a Roth 401(k) or Roth IRA followed by a 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 withdrawal from your 401(k).
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.