Yes, in some cases you are able to take funds from your 401(k) to purchase a house. Your Roth IRA and/or traditional IRA would be a better source of funds, however, if you are a first-time home buyer. You would also be better off if you continued to save additional money to purchase a home instead of drawing it from your retirement accounts. That’s because the funds you take from your retirement account cannot be made up—and there is an opportunity cost to this decision.
For example, if you leave $10,000 in your IRA or 401(k) instead of using it for your home purchase, that $10,000 could potentially grow to become $54,000 in 25 years with a 7% annualized return. If you leave $20,000 in your 401(k) or IRA, that $20,000 could grow to $108,000 in 25 years, earning the same 7% return.
- If you have a 401(k), you might think about taking a loan from that account instead of withdrawing money from your IRA.
- IRA early withdrawals may incur no penalty if used properly to purchase a first home.
- In general, you can borrow up to 50% of your 401(k) balance—up to a maximum of $50,000—for any reason without incurring taxes or penalties.
- You’ll pay interest on the 401(k) loan, typically the prime rate plus one or two percentage points, which will go back into your retirement account.
- In most cases you have to repay the loan within five years, but if you’re using the money for a house, the repayment schedule may be extended to as many as 15 years.
Look to Your IRAs First
If you absolutely must take a distribution from one of your accounts, the best move would be to take a distribution from your Roth IRA—if you have one. Roth IRA holders are able to take contributions from their Roth IRA tax free as well as earnings up to $10,000 tax free.
If you do not have a Roth IRA, then 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.
If your 401(k) is your only source for a distribution, there are two potential ways to take this distribution (if your plan allows for these distributions): a loan or a hardship distribution.
One suggestion would be that you take a loan from your 401(k). That’s because it represents a non-taxable event and you can pay yourself back. You are eligible to take a loan amount equal to the lesser of half your account value, or $50,000. Before taking a loan, be sure to use your plan’s loan calculator function to determine how much you will owe each month—and to confirm that you can afford to make the loan payment. The maximum loan term is five years.
The least favorable method for funding your purchase is taking a distribution under the IRS’s hardship rules. Your company’s retirement plan would need to allow hardship distributions for this to be possible. And the plan might require you to first take a loan before taking a hardship distribution. This distribution would be fully taxable. If you are under 59.5 years old, a 10% penalty would also be applied.
The Bottom Line
To sum up: Saving funds in your bank or investment account is typically the best option for a home purchase instead of taking a distribution from one of your retirement accounts. If you absolutely need to take a distribution toward putting a down payment on a home, the first account you should target is your Roth IRA, followed by your traditional IRA, and then 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, 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.