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 are allowed to use funds from your 401(k) plan to buy a home. It is not the best move, however, because there is an opportunity cost in doing so; the funds you take from your retirement account cannot be made up easily.
Here's a look at the details of tapping your 401(k) for the joys of homeownership, along with some better alternatives. Throughout, we'll assume that you are under 59½ years old and still employed.
- 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 does not incur income taxes or tax penalties.
- 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 Quick Review of the 401(k) Rules
A 401(k) account is earmarked to save for retirement—that's why account holders get the tax breaks. In return for giving a deduction on the money contributed to the plan and for letting that money grow tax-free, the government severely limits account holders' access to the funds.
Not until you turn 59½ are you supposed to withdraw funds—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 If neither is the case, and you do take money out, you incur a 10% early withdrawal penalty on the sum withdrawn. To add insult to injury, account holders also owe regular income tax on the amount (as they would with any distribution from the account, whatever their age).
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).
Of the two, borrowing from your 401(k) is 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. 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 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 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 for these repayments, either. 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.
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 a 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.
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.
Drawbacks to Using 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.
Alternatives to Tapping Your 401(k)
If you must tap into retirement savings, it's better to look at your other accounts first—specifically 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 owing 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 (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 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 hardship distribution from your 401(k).
Dan Stewart, CFA®
Revere Asset Management, Dallas, Texas
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.
Can you really use your 401(k) to buy a house?
The short answer is yes, since it is your own 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 from the IRS. 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 is a 401(k) loan?
A 401(k) loan allows an account holder to borrow against their savings held within the account. Loans of this type don't trigger the 10% early withdrawal penalty that occur when money is permanently taken out of a 401(k). There are limits to the repayment terms and amount that can be borrowed - generally a 401(k) loan must be repaid within five years (though longer terms can b e available if used for a principal residence) and the amount of the loan is limited to half of the account balance or $50,000, whichever is less.
What is a 401(k) withdrawal
As the term implies a 401(k) withdrawal is simply pulling money out of a 401(k) account, which can be done at any time - up to the limit of the account balance. There is a significant cost to withdrawing funds from a 401(k) before the age of 59 1/2, however, as the IRS imposes an early withdrawal penalty of 10%. Early withdrawals from these qualified retirement accounts is not recommended, unless needed as a last resort. Even then, there are alternatives such as hardship withdrawal provisions that can shield account holders from tax penalties if they meet certain conditions and are then simply taxed as regular income.