Can a 401(k) Be Used for a House Down Payment?

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

Key Takeaways

• You can withdraw funds or borrow from your 401(k) to use as a 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 wise to try to not take or borrow cash from your 401(k)—and your future.

Withdrawing From a 401(k)

The first and least advantageous way is to withdraw the money outright. This comes under the rules for hardship withdrawals, which were recently expanded to allow 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), according to the Internal Revenue Service (IRS).

Pro

• You get money you need for a down payment.

Cons

• You owe income tax on the withdrawal.

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

• If you are younger than 59½, you 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.

Important

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

Borrowing From a 401(k)

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

Pros

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

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

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 will 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. The repayment time frame is now 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 10% penalty tax if you are younger than age 59 ½, 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 to contribute to the plan until you have paid off the loan.

Is It a Good Idea to Use a 401(k) to Buy a House?

Whether or not it’s a good idea to use your 401(k) funds to buy a home depends on your circumstances. However, the downsides may outweigh the positives, because withdrawing or borrowing from your 401(k) puts those funds on a different track, away from their original job: compound growth for your retirement. Weigh your options carefully, and think about your future.

Can I Use My 401(k) to Pay Off Debt?

Paying off debt is not a hardship withdrawal, as defined by the IRS. This means that if you withdraw these funds, and you’re under 59 ½ years old, you’ll need to pay a 10% early withdrawal penalty on top of the typical income tax. So while it’s possible, it may not be advisable. An exception may be credit card debt, which often means double-digit interest rates. Still, it’s wise to consider if you’re living beyond your means—and if you have the ability to change that before going into debt again.

Is It Better to Max Out 401(k) or Pay Off Debt?

If your debt has interest rate of about 5% or greater, it’s probably better to pay off that debt before investing it in a retirement account. This is because most 401(k)s have a rate of return of 5% to 8%. It’s also wise to create an emergency fund before devoting your attention to paying down debt.

The Bottom Line

While your 401(k) is an easy source of down payment funds, consider finding an alternate source for these funds, rather than taking or borrowing from your future. If you do need to resort to using these funds, it’s typically preferable to borrow them, rather than taking a withdrawal and losing these tax-advantaged savings forever.

Read the original article on Investopedia.