If you’re looking for a way to fund a down payment, using 401(k) withdrawals for a home purchase is an option. Additionally, you could opt for a 401(k) loan for a home purchase. However, cashing out a 401(k) to buy a house comes with significant consequences.
Read on to learn about the ins and outs of using a 401(k) for a house down payment.
Can I use my 401(k) to buy a house?
Yes, you can use your 401(k) for a house down payment, but there is a lot to consider before moving forward with this strategy. Depending on how you tap into your 401(k), the amount you take out may be subject to income tax. And if you’re under age 59½, you may have to pay an additional 10% early withdrawal penalty.
Because 401(k) plans are a vehicle for retirement savings, the government doesn’t make it easy to access them outside of their intended purpose. Your 401(k) contributions and earnings are tax-deferred until retirement, so withdrawing the money before then comes at a price and with some difficulty.
However, the money you save in a 401(k) is yours, so there are avenues to access it, such as hardship distributions, early withdrawals, and loans. Keep in mind that any withdrawal made before the plan’s retirement age — regardless of the reason — is considered an early distribution and is generally not recommended. Besides the immediate cost and tax implications of cashing out a 401(k) to buy a house, you’ll also be impacting your long-term financial security.
Can you use a 401(k) to buy a house?: Two paths you can take
There are two paths to cashing out a 401(k) to buy a house: taking an early distribution or borrowing against your 401(k) balance. Here’s an overview of both options:
|401(k) Withdrawals for Home Purchase||401(k) Loan for Home Purchase|
|Subject to Income Tax||Yes||No (if conditions are met)|
|Subject to 10% Early Withdrawal Tax||Yes (if you’re under 59½)||No (if conditions are met)|
|Needs to Be Repaid||No||Yes|
|Maximum Amount||Up to your contributions (some earnings may be accessible)||The lesser of $50,000 or 50% of your vested account balance|
Is it worth taking a 401(k) withdrawal to buy a house?
Taking a 401(k) withdrawal for a house can be a costly way to fund your home purchase. You’ll pay income taxes on the distribution — most likely at a higher rate than you would when withdrawing funds during your retirement years. And unless you’re 59½ or older, you’ll pay an additional 10% penalty on the withdrawal.
Besides the immediate costs, using your 401(k) for a house down payment has long-term consequences. You’ll be removing money from your nest egg — money that may be harder to replace later on. And you’ll be unplugging a chunk of your money from future growth.
|Note: Withdrawing money from your 401(k) for a house down payment and other purchase costs qualifies as a hardship distribution as long as it’s for your primary residence. But the withdrawal will still be subject to income tax and, if you’re under 59 ½, the 10% early withdrawal penalty.|
What using your 401(k) for a house down payment can cost you
Homebuyers who use 401(k) withdrawals for home purchases may be solving their short-term cash-flow issue, but they’re doing it at the expense of their future financial stability.
Let’s look at how taking out a 401(k) withdrawal for a house down payment can impact your future earnings. In this example, our borrower is 35 years old, has $75,000 in their 401(k) account, and wants to withdraw $10,000 for their home purchase. We’ll compare the potential growth of the account with and without the withdrawal based on a 7% annualized return.
|Starting 401(k) Balance||401(k) Withdrawal||401(k) Balance After 25 Years|
As you can see from this illustration, unplugging $10,000 from a $75,000 balance means our borrower is missing out on over $54,000 of growth. And because our borrower is under age 59 ½, the $10,000 withdrawal was taxed and penalized.
How to take a 401(k) loan for a home purchase
An alternative to 401(k) withdrawals for a home purchase is to borrow against your 401(k) balance. Loans differ from distributions because you have to pay the money back to your account with interest. As a result, 401(k) loans are not subject to income tax or the early withdrawal penalty tax as long as you repay the loan as agreed.
While taking a loan from your 401(k) can be a less expensive option than using a 401(k) withdrawal for a house down payment, it has drawbacks. Like using 401(k) withdrawals for a home purchase, you’ll be eating into your retirement funds and removing the money from future earnings potential. Also, you may incur loan fees, and you’ll be paying back the loan at market interest rates — similar to what you’d pay on a personal loan and higher than what you’d pay on a mortgage-related product. And since you typically repay 401(k) loans through payroll deductions, your net income will be lower while you’re repaying the loan.
Additionally, you’ll be paying the 401(k) loan back with after-tax dollars, and then the money will get taxed again when you withdraw funds during your retirement years. This double tax is counterproductive to one of the primary benefits of contributing to a 401(k) plan.
What you should know about using a 401(k) loan for a home purchase
Not all 401(k) plans allow loans, but many employers, especially larger companies, offer a loan feature. Your plan paperwork will indicate if it provides 401(k) loans, or you can check with your plan’s administrator.
Before taking a loan from your 401(k), make sure you have a plan. Only withdraw what you need (keep in mind that 401(k) loans are limited to the lesser of $50,000 or 50% of your vested account balance), and make sure you know how you’ll repay the loan. The typical 401(k) loan term is five years, during which borrowers will need to make similarly equal payments at least quarterly. Although, in the case of a 401(k) loan for a home purchase, borrowers have longer to pay the loan back — up to 25 years with some plans.
Another factor to consider is that if you leave your job or are terminated, your employer may require you to pay the outstanding balance. If you’re unable to pay it within the specified time — typically 90 days — the money will be counted as income. You’ll pay income tax at your current rate as well as the 10% early withdrawal penalty if you’re under 59 ½.
Alternatives to using a 401(k) to buy a house
Again, cashing out a 401(k) to buy a house has significant implications and expenses both immediately and down the road. If that’s your only way to fund a down payment, perhaps delaying the purchase can give you more time to save. But if you’re looking to buy a home sooner rather than later, make sure you consider all your options before resorting to 401(k) withdrawals for a home purchase.
Unplugging retirement funds of any kind is not ideal. Still, an IRA withdrawal for a home purchase may have less severe consequences than using your 401(k).
If you’re under 59½, Roth and Traditional IRA withdrawals are typically subject to the 10% early distribution penalty. However, first-time homebuyers and those who haven’t owned their home in the past two years are exempt from the 10% early distribution tax — up to $10,000 — when using an IRA withdrawal for a home purchase.
Keep in mind you can usually withdraw IRA contributions without tax consequences as long as you take them out ahead of the tax filing deadline for the calendar year you made them.
First-time homebuyer programs
If you’re a new buyer or haven’t owned your primary residence in the past three years, you may be eligible for first-time homebuyer programs in your state. Typically, first-time homebuyer programs include various forms of assistance, such as low-interest loans, down payment help, and tax credits. Your state HUD office can point you to available programs.
Down payment assistance programs
Even if you’re not a first-time homebuyer, you may be eligible for state-wide or local down payment assistance programs. Down payment assistance comes in many forms, including traditional second mortgages, forgivable second mortgages, and grants.
Home loans with low minimum down payments
Be sure you’re aware of all your mortgage options. Some home loan programs have no or low minimum down payments. For example, VA and USDA borrowers can purchase a home with no money down. FHA loans require only a 3.5% down payment, and some conventional loans have a 3% minimum down payment.
Do you need help weighing the pros and cons of 401(k) withdrawals for a home purchase? A local Finance of America Mortgage Advisor can help you explore your options.