Withdrawing money from a 401(k) to buy a house may be allowed by your company-sponsored plan, but this tactic is not always advisable, especially for first-time home buyers.
When it comes to using money from a 401(k), first-time home buyers need to keep in mind a few things, including the rules and penalties around early withdrawals from a 401(k) account — as well as the potential loss of retirement savings.
Before you consider using a 401k to buy a house, consider alternatives like withdrawing funds from a Roth IRA, seeking help from a Down Payment Assistance Program (DAP), or seeing if you qualify for other types of home loans.
Let’s take a look at the pros, cons, and important considerations that can help prospective homebuyers make a more informed decision about using funds from a 401(k) to buy a home.
Can You Use a 401(k) to Buy a House?
Before you quickly search up “401k first time home buyer,” here’s the answer: If you’re a first-time home buyer, and your employer plan allows it, you can use your 401(k) to help buy a house. There are a couple of ways to access the funds.
First, it’s possible for a first-time homebuyer to take a loan from an existing 401(k). Your employer generally sets the rules for 401(k) loans, but you typically must pay back the loan, with interest, within five years. You pay yourself interest to help offset the loss of investment growth, since the funds are no longer invested in the market.
You can take out a 401(k) loan for a few different reasons (e.g., qualified educational expenses, medical expenses), depending on your plan’s policies. Those using a loan to purchase a residence may have more time to pay back the loan.
In certain rare circumstances, in the case of an “immediate and heavy financial need,” the IRS will allow you to make a 401(k) hardship withdrawal to purchase a primary residence. Hardship withdrawals do not cover mortgage payments, but using a 401(k) for a down payment for a first-time home buyer could be allowed.
The IRS has very strict rules for qualifying for a hardship withdrawal. And if you don’t meet them, the funds you withdraw will be subject to income tax and a 10% early withdrawal penalty.
How Much of Your 401(k) Can Be Used For Home Purchase?
Generally, home buyers who want to use their 401(k) funds to finance a real estate transaction can borrow or withdraw up to 50% of their vested balance or a maximum of $50,000 — whichever is less. This limit typically applies to any 401(k) loan, not only a home purchase.
4 Potential Drawbacks of Using Your 401(k) to Buy a House
Taking money out of a 401(k) to buy a house may be allowed, but it’s not always recommended.
1. Withdrawal limits
Since there are limits on the amount you can withdraw or borrow for a home purchase, bear in mind that the total amount you can access may not cover all the costs (e.g., the down payment and closing costs) of the transaction. Be sure to run the numbers, to ensure that a 401(k) loan makes sense.
2. Lost contributions
Homebuyers who borrow from their 401(k) plans can’t make additional contributions to the accounts or receive matching contributions from their employers while paying off the loan. Depending on how much they were contributing, these home buyers could miss out on years of retirement contributions while they’re paying back the loan. That could take a substantial bite out of their overall retirement savings.
3. Automatic repayment terms
Generally, it’s not up to you to repay the loan; your company will deduct the loan payments automatically from your paycheck. This could be viewed as a convenience, since you don’t have to think about it, or as an inconvenience, as it lowers your take-home pay.
4. Loan terms change if you leave your job.
Finally, if an individual borrows from their 401(k) to purchase a home and leaves employment at their company (whether voluntarily or via layoff), the loan balance may be deducted from their remaining 401(k) funds in what’s called an offset. An offset is then treated like an early withdrawal, and potentially subject to taxes and a 10% penalty if the borrower is under 59½.
As an example: Derek is 35 and has $100,000 in his 401(k) and borrows $30,000 for a home purchase. He pays back $5,000 including interest, but still owes $25,000 when he takes another job. The remaining $25,000 would be deducted from his 401(k) as an offset, leaving $75,000 in the 401(k) or rollover IRA. Worse, the $25,000 would be treated by the IRS as an early withdrawal or distribution, and Derek would owe taxes, plus a 10% penalty ($2,500).
Terms may vary depending on the terms of your loan, the plan rules, and whether you were impacted by Covid-19, and would be considered a “qualified individual” under the CARES Act.
Pros and Cons of Using a 401(k) to Buy a House
Here are the pros and cons of using a 401(k) to buy a home, at a glance:
What are the Rules & Penalties for Using 401(k) Funds to Buy a House?
Here’s a side-by-side look at some key differences between taking out a 401(k) loan and withdrawing funds from a 401(k).
What are the Alternatives to Using a 401(k) to Buy a House?
For some first-time homebuyers, there may be other, more attractive options for securing a down payment than taking money out of a 401(k) to buy a house. Here are a few of the alternatives.
Withdrawing Money from a Roth IRA
Using a Roth IRA to help buy a first home can be a smart alternative to borrowing from a 401(k) that might be beneficial for some home buyers. Unlike 401(k)s, Roth IRA contributions are made with after-tax dollars.
Contributions can be withdrawn at any time, tax free; earnings can be withdrawn without a penalty at age 59½ or older, as long as you’ve held the account for at least five years.
If you’re under 59½ or don’t meet the five-year criteria, some exceptions may apply for a first-time home purchase.
- After the account has been open for five years, Roth IRA account holders who are buying their first home are allowed to withdraw up to $10,000 in investment earnings with no taxes or penalties. (Meaning a person could withdraw the amount of their total contribution plus up to $10,000 in investment earnings.) The $10,000 is a lifetime limit.
- Roth IRA funds can be used to help with the purchase of a first home not only for the account holders themselves, but for their children, parents, or grandchildren.
- One important requirement to note is that time is of the essence when using a Roth IRA to purchase a first home: The funds have to be used within 120 days of the withdrawal.
Low- and No-Down-Payment Home Loans
There are certain low- and no-down-payment home loans that homebuyers may qualify for that they can use instead of using a 401(k) for a first time home purchase. This could allow them to secure the down payment for a first home without tapping into their retirement savings.
- FHA loans are insured by the Federal Housing Administration and allow home buyers to borrow with few requirements. Home buyers with a credit score lower than 580 qualify for a loan with 10% down, and those with credit scores higher than 580 can get a loan with as little as 3.5% down.
- Conventional 97 loans are Fannie Mae-backed mortgages that allow a loan-to-value ratio of up to 97% of the cost of the loan. In other words, the home buyer could purchase a house for $400,000 and borrow up to $388,000, leaving only a down payment requirement or 3%, or $12,000, to purchase the house.
- VA loans are available for U.S. veterans, active duty members, and surviving spouses, and they require no down payment or monthly mortgage insurance payment. They’re provided by private lenders and banks and guaranteed by the United States Department of Veterans Affairs.
- USDA loans are a type of home buyer assistance program offered by the U.S. Department of Agriculture to buy or possibly build a home in designated rural areas with an up-front guarantee fee and annual fee. Borrowers who qualify for USDA loans require no down payment and receive a fixed interest rate for the lifetime of the loan. Eligibility requirements are based on income, and vary by region.
Other Types of Down Payment Assistance
For home buyers who are ineligible for no-down payment loans, there are a few more alternatives instead of using 401(k) funds:
- Down Payment Assistance (DAP) programs offer eligible borrowers financial assistance in paying the required down payment and closing costs associated with purchasing a home. They come in the form of grants and second mortgages, are available nationwide, can be interest-free, and sometimes have lower rates than the initial mortgage loan.
- Certain mortgage lenders provide financial assistance by offering credits to cover all or some of the closing costs and down payment.
- Gifted money from friends or family members can be used to cover a down payment or closing costs on certain home loans.
Generally speaking, a 401(k) can be used to buy a house, either by taking out a 401(k) loan and repaying it with interest, or by making a 401(k) withdrawal (which is subject to income tax and a 10% withdrawal fee for people under age 59½).
However, using a 401(k) for a first-time home purchase is usually not advisable. Both qualified loans and withdrawals have some potential drawbacks — primarily the possibility of owing taxes and a penalty under certain conditions. Fortunately, there are other options. Certain Roth IRA withdrawals can be made tax and penalty free. Qualified homebuyers can also seek financial help from down payment assistance programs and other low- or no-interest plans.
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