Taking money out of a 401(k) is a financial tactic many home buyers can use to get their arms around their dream house, but the question of whether they should is another story.
When it comes to using money from a 401(k), first-time homebuyers might want to keep a few things in mind. It can be helpful to first assess the rules around early withdrawal from a 401(k) account, including limitations and penalties associated with the transaction.
If you find yourself asking “Can I use my 401(k) to buy a house?” it also might be worth considering other alternatives like withdrawing funds from Roth IRAs, seeking Down Payment Assistance, or seeing if you qualify for other types of home loans.
Reading these pros, cons, and important considerations can help prospective homebuyers make a more informed decision.
Can You Use a 401(k) to Buy a House?
Long story short: Yes, you can use your 401(k) to buy a house. There are two different ways to access the funds:
It’s possible for a first-time homebuyer to take a loan from an existing 401(k) under the condition it will be repaid with interest (though the interest goes back to you).
In some cases it’s also possible for a first-time homebuyer to permanently withdraw funds from a 401(k) account, under the condition that a 10% penalty fee and income tax will be paid upon withdrawal. This criteria is important to fulfill when looking into 401(k) hardship withdrawals.
How Much 401(k) Can Be Used For Home Purchase?
Typically, 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—as long as they’re using the money exclusively to purchase a home.
Potential Drawbacks of Using Your 401(k) to Buy a House
Taking money out of a 401(k) to buy a house is allowed but not always recommended.
First, since one of the immediate limitations to using 401(k) funds is the amount that can be taken, it might not cover the cost of the entire purchase plus closing fees.
Second, 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 regularly contributing, these home buyers could miss out on years of retirement contributions while they’re paying back the funds; that could be enough to make a substantial dent in their overall retirement savings.
Finally, if an individual borrows from their 401(k) to purchase a home and loses employment at their company (whether voluntarily or via layoff), the repayment period shortens and they’ll need to pay back the loan by the end of that year’s tax filing date. If the homebuyer fails to pay off the loan by then, it will typically be subject to a 10% penalty and taxed as income.
What are the Rules & Penalties for Using 401(k) Funds to Buy a House?
This chart outlines some key differences between taking out a 401(k) loan and withdrawing funds from a 401(k).
|401(k) loans||401(k) withdrawals|
• Must be repaid with interest in a certain period of time—usually 5 years
• Penalty-free and tax-free
• The maximum loan amount is 50% of the vested account balance, or $50,000, whichever is less. (For accounts with a vested account balance of less than $10,000, the maximum loan amount is $10,000.)
• Interest accrued on the loan goes back into the 401(k), so the borrower is basically paying interest back to themselves
If the borrower doesn’t repay the loan in time, the loan is treated as a regular distribution (aka withdrawal) and subject to an early withdrawal penalty and taxed immediately
|• Do not have to be repaid
• Subject to income tax on the funds removed and a 10% early withdrawal penalty for people under age 59 ½
• One can only withdraw enough to cover the immediate expense (a down payment, for example, not future monthly mortgage payments), with a limit of 50% of the vested balance or $50,000—whichever is less
• Usually allowed only in the case of “financial hardship,” which can include medical expenses, funeral expenses, and primary home-buying expenses
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. These are a few of the alternatives.
Withdrawing Money from a Roth IRA
Using a Roth IRA to buy a first home is one alternative to borrowing from a 401(k) that can be beneficial for some home buyers. Unlike 401(k)s, Roth IRA contributions are made with after-tax dollars. This means at the time of the withdrawal, the funds can be taken out tax-free (if the recipient is 59 ½ or older).
Other reasons why it might make sense to use a Roth IRA to purchase a first home:
• Roth IRA contributions can be withdrawn without penalty at any time.
• 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.)
• 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 last 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 first-time homebuyers may qualify for. This could allow them to secure the down payment for a first home without tapping into their retirement savings (either temporarily or permanently):
• FHA loans are insured by the Federal Housing Administration and allow home buyers to borrow with fewer 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 only 3.5% down.
• Conventional 97 loans are Fannie Mae-backed mortgages that allow a loan-to-value ratio of up to 97%, i.e. the home buyer could purchase a house for $400,000 and borrow up to $388,000, leaving only a $12,000 down payment requirement 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 to turn to instead of using a 401(k) to purchase a house:
• Down Payment Assistance (DPA) 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.
A 401(k) can be used to buy a house, either by taking out a 401(k) loan and repaying it with interest (but no penalties or income tax), or by making a 401(k) withdrawal (which is subject to income tax and a 10% withdrawal fee for people under the age of 59 ½).
But there are other options. Roth IRA withdrawals can be made tax- and penalty-free. Qualified homebuyers can also seek financial help from FHA loans, Conventional 97 loans, VA loans, USDA loans, DPA programs, and gifts from family members or friends.
Regardless of how homebuyers squirrel away the funds for a new home purchase, they can still prepare for a better financial future long after they’ve been handed the keys.
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