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's not the best move, though. 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 whys and wherefores of tapping your 401(k) for the joys of homeownership, along with some better alternatives. Throughout, we'll assume that you are under 59 ½ 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 it's 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 401(k) rules. These accounts are earmarked to save for retirement—that's why you get the tax breaks. 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 59 ½ are you supposed to withdraw them—or age 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If neither is the case, and you do take money out, you are dinged with a 10% early withdrawal penalty on the sum you've withdrawn.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 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).

401(k) Loans

Of the two, borrowing from your 401(k) is the more desirable option. 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.

Still, 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/administrator.

Generally, the maximum loan term is five years, though if you take a loan to buy a principal residence, you may be able to pay it back over a longer period of 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. 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.

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.

You are likely to incur a 10% penalty on what 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 not limited in the amount you can take out, 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 the 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 Roth IRA—if you have one. You can withdraw your Roth IRA contributions at any time, for any reason, without tax or penalty. You can also withdraw up to $10,000 of earnings tax-free if the money is used for a first-time home purchase.

The next choice would be to take a distribution from a traditional IRA. 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).

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.