The funds in your 401(k) retirement plan can be tapped to raise a down payment for a house. You can either withdraw or borrow money from your 401(k). Each of these options has major drawbacks that could outweigh the benefits.

KEY TAKEAWAYS

  • You can withdraw funds or borrow from your 401(k) to use as down payment on a home.
  • Choosing either route has major drawbacks, such as an early withdrawal penalty and losing out on tax advantages and investment growth.
  • It's obviously better if you can save the money elsewhere and not take or borrow the cash from your future.

Withdrawing from a 401(k)

The first and least advantageous way is to simply withdraw the money outright. This comes under the rules for hardship withdrawals, which were recently made a little easier, allowing account holders to withdraw not just their own contributions, but those from their employers. Home-buying expenses for a "principal residence" is one of the permitted reasons for taking a hardship withdrawal from a 401(k).

Pro

  • You get money you need for a down payment.

Cons

  • You owe income tax on the withdrawal.

  • The withdrawal could move you to a higher tax bracket.

  • If you are younger than 59½, you also owe a 10% penalty on the money you withdraw.

  • You can never repay your account and lose years of tax-free earnings on the money you withdraw.

If you withdraw money, however, you owe the full income tax on these funds, as if it were any other type of regular income that year. This can be particularly unappealing if you are close to a higher tax bracket, as the withdrawal is simply added on top of the regular income. There is a 10% penalty tax, also known as an early withdrawal penalty, on top of that if you are under 59½ years of age.

401(k) plans do not have a first-time homebuyer exception for early withdrawals but IRAs do.

Borrowing from a 401(k)

The second way is to borrow from the 401(k). You can borrow up to $50,000 or half the value of the account, whichever is less, as long as you are using the money for a home purchase. This is better than simply withdrawing the money, for a variety of reasons.

Pros

  • You can borrow up to $50,000 or half the value of the account.

  • The interest you pay on the loan is paid to your own account, not to a bank.

  • If you leave your job and must repay the loan, the repayment period was increased to the due date of your federal income tax return, instead of the previous 60-to-90 day window, under the Tax Cuts and Jobs Act.

Cons

  • You need to repay the loan, generally within five years.

  • You have to disclose this loan to the bank if you are applying for a mortgage.

  • If you leave your job, you must repay the loan by the due date of your federal income tax return or the loan will be considered a withdrawal, triggering income taxes and a possible 10% early withdrawal penalty if you are under 59½.

  • Depending on your plan, you may not be able to contribute to your 401(k) until you pay off the loan.

  • Even though you're paying interest, you lose out on potential investment growth of the funds.

For starters, although you are charged interest on the loan—the interest rate is typically two points over the prime rate. However, you are effectively paying interest to yourself rather than to the bank. And it means you are earning at least a little money on the funds you withdraw.

The downside is that you need to repay the loan, and the time frame is normally no more than five years. With a $50,000 loan, that's $833 a month plus interest. You must disclose this to the bank when you're applying for a mortgage since it could potentially drive up your monthly expenses.

Prior to the Tax Cuts and Jobs Act of 2017 if your employment ended before you repaid the loan, there was typically a 60-to-90-day repayment window for the full outstanding balance. Staring in 2018, the tax overhaul extended the repayment time frame until the due date of your federal income tax return, which also includes filing extensions.

Failure to repay the loan in that time frame triggers the regular taxation and 10% penalty tax, as the outstanding balance is then considered to be an early withdrawal.

Another major downside is that borrowing from your 401(k) means you lose out on the potential investment growth of those funds. In addition, some 401(k) plans don't allow you contribute until you have paid off the loan.

While your 401(k) is an easy source of down payment funds, it's obviously better if you can save the money elsewhere and not take or borrow the cash from your future. If you do need to resort to using the funds, it's obviously better to borrow them than to take a withdrawal and lose these tax-advantaged savings forever.