A 401(k) is a tax-qualified retirement account that provides tax benefits to employees and the self-employed. By charging a 10 percent penalty on early withdrawals, the accounts are structured to discourage you from withdrawing money before retirement.
Tip
You can use withdrawals from your 401(k) to purchase a second home, but you could be slapped with a 10 percent tax penalty. However, there are a several exceptions you might be able to use to sidestep the penalty. Withdrawals are not state-specific regarding penalties, but your state income tax may be affected.
Traditional 401(k) Penalty Exceptions
A traditional 401(k) provides a tax deduction on contributions, and taxes withdrawals as ordinary income. Normally, early withdrawals (before age 59 ½) are subject to a 10 percent penalty tax, but exceptions are available. Early withdrawals escape the penalty if they result from job separation after age 55, rollover into another retirement account, death, total disability, financial hardship, medical bills exceeding 7.5 percent of your adjusted gross income or substantially equal regular payments based on your life expectancy. Even if you meet one of these exceptions, it's important to keep in mind that if you withdraw money from your traditional 401(k) to purchase a home or for any other reason, that money will still be taxed as income.
Roth 401(k) Penalty Exceptions
A Roth-style 401(k) allows you to withdraw the money you've contributed at any time tax- and penalty-free. But a withdrawal of earnings on contributions will be accompanied by some fees, such as income tax and a 10 percent penalty, without exception, during the first five years following the initial contribution to the account. Otherwise, earnings withdrawals before age 59 ½ follow traditional 401(k) rules regarding penalties and exceptions.
Borrowing from Yourself
Unlike individual retirement accounts, 401(k)s allow you to borrow from them without triggering taxes or penalties, as long as you follow the rules. Those rules require you to charge yourself the market rate for interest (that is, 1 percentage point above the prime rate) and to repay the loan within five years. The maximum you can borrow is the lesser of half your vested balance and $50,000. You can use the borrowed money for any purpose, including helping to pay for a second home.
Investing in Rental Properties
One interesting way to use a 401(k) is to purchase rental property. That is, the 401(k) can own the property and receive rental income tax-deferred. The 401(k) custodian must allow for real estate transactions. For example, self-employed individuals can use a self-directed Solo 401(k) to buy income property. If you buy a second home this way, you cannot live in it nor provide any services to manage or maintain the property. You, your family and certain other individuals are disqualified from occupying the home, becoming tenants in the home, or otherwise receiving any personal benefit from it. The 401(k) can own a mortgage on the property, as long as the mortgage is collateralized only by property and doesn’t make the account owner personally liable for the loan.
Can I use my 401(k) to buy a house?
Using your 401(k) to make a down payment on a house is generally allowed. And there are even some benefits: 401(k) loans aren’t taxed and they have low interest rates.
However, borrowing from your 401(k) can do severe and lasting damage to your retirement savings. So it’s generally not recommended as a down payment source.
Before you decide to use your 401(k) to buy a house, consider the no- and low-down-payment mortgages available today.
Many people can buy a house with as little as 3% or even 0% down — so there’s a good chance you don’t need to tap your retirement savings to make a down payment.
In this article (Skip to…)
- 401(k) to buy a house
- 401(k) loans
- 401(k) withdrawals
- First-time buyers
- Alternatives to 401(k)s
- 401(k) money to avoid PMI
- Ask a financial advisor
- Check your options
Using your 401(k) to buy a new home: Allowed but not recommended
You likely can’t use your 401(k) to buy a house flat-out since there are limits to the amount of money you can take out.
It is possible to use your 401(k) to cover the down payment and closing costs on a home purchase. But as most financial experts will tell you, using your 401(k) to purchase a home typically isn’t the best idea.
You have plenty of alternatives to your 401(k) to get cash for a down payment — ones that won’t have the same long-term ramifications as taking money from your retirement savings.
You can read up on other ways to get money for a down payment below.
But maybe you’ve already looked at all your options and decided the money in your 401(k) is the best way to get the cash you need to purchase a home.
In that case, there are two ways you can access your 401(k) funds.
- 401(k) loan: You can take a loan from your 401(k) account, which will need to be repaid with interest
- 401(k) withdrawal: Or you can simply withdraw the money, which comes with a 10% penalty and income tax from the IRS. Although the penalty hit differs depending on your age group
Here are the pros, cons, and rules for each method.
How to use a 401(k) loan to buy a house
A 401(k) loan is the preferred method if you need to cash out some of your 401(k) retirement funds to buy a house. That’s because there’s a much lower cost associated with a 401(k) loan compared to a 401(k) withdrawal.
You should also know:
- A 401(k) loan is usually not counted in your debt-to-income ratio, so it won’t hurt your chances of mortgage qualifying
- 401(k) loans are not reported to credit bureaus, so applying for one won’t harm your credit score
“Depending on the program and the underwriter, they may hit you for this payment in terms of DTI, even though it isn’t on your credit report,” cautions Jon Meyer, The Mortgage Reports loan expert and licensed MLO.
Downsides to 401(k) loans for home buying
While you’re paying back the 401(k) loan, you usually can’t make new contributions to your retirement account. And that means your employer won’t be matching contributions, either.
All told, you could miss out on five years or more of retirement contributions — and five years of compound interest on those funds — which will likely make a big dent in your savings later in life.
Qualified 401(k) loans are penalty free. But if you leave your current company or are laid off while you have an outstanding 401(k) loan, the repayment period shortens. In that case, you’d have to repay the loan by that year’s tax filing date.
- For example, if you take out a 401(k) loan on October 1, 2022, then leave your job on December 1, 2022, your entire loan would need to be repaid by April 15, 2023
If your 401(k) loan is not repaid by its due date, the remaining balance is treated as a 401(k) withdrawal, meaning it’s taxable income and subject to a 10% penalty.
Can I use my 401k to buy a house without penalty?
Unlike a 401(k) withdrawal, a 401(k) loan is not subject to a 10% early withdrawal penalty from the IRS. And the money you receive will not be taxed as income.
The rules for using a 401(k) loan to buy a house are as follows:
- Your employer must allow 401(k) loans as part of its retirement plan
- The maximum loan amount is 50% of your 401(k)’s vested account balance or $50,000, whichever is less
- The loan must be paid back with interest (typically the prime rate plus 1-2%), on a schedule agreed to by you and your 401(k) provider
- Typically, you cannot make 401(k) contributions while you have an outstanding 401(k) loan
Also, 401(k) loans typically need to be paid back over five years.
However, when the money is used to purchase a home, you’re usually allowed to pay it back over a longer period of time. Rules vary by 401(k) company, so check with yours to learn more.
Using a 401(k) withdrawal to buy a house
401(k) withdrawals are generally not recommended as a means to buy a house because they’re subject to steep fees and penalties that don’t apply to 401(k) loans.
If you take a 401(k) withdrawal before age 59½, you’ll have to pay:
- A 10% early withdrawal penalty on the funds removed
- Income tax on the amount withdrawn
For example, say you withdraw $20,000 from your 401(k) to cover your down payment and closing costs.
- You’ll be charged a $2,000 (10%) early withdrawal penalty
- And you’ll have to pay income tax on the $20K, which likely comes out to around $4,000-$6,000
That’s up to $8,000 gone from your retirement savings, on top of the initial withdrawal.
The standard rules for 401(k) withdrawals are as follows:
- Most 401(k) plans allow withdrawals only in cases of financial hardship
- However, using the money to buy a primary residence often qualifies as a financial hardship withdrawal
- You can withdraw only the money required to cover your immediate need
- The money does not have to be repaid
Since the IRS considers 401(k) withdrawals as ordinary income, withdrawing 401(k) money could bump some home buyers into a higher tax bracket. This could add even more to the cost of the early withdrawal.
Coronavirus update:
The CARES Act provision allowing for tax-free withdrawals from a 401(k) expired on Dec. 31, 2020. The IRS’s normal 10% penalty is being enforced on hardship withdrawals in 2022.
Using your 401(k) for a down payment as a first-time home buyer
Home prices keep rising — which means saving the required down payment for your first-time home purchase can be tough.
But as a first-time home buyer, taking money from your 401(k) to buy a home is likely not the best option.
First-time home buyers are often at a key age for making retirement contributions. The more cash you put in when you’re young, the more time your money has to accrue compound interest.
By taking money out of your 401(k) to get a mortgage loan, you can seriously reduce the amount in your savings when you’re ready to retire.
For example:
- Say you have $30,000 in your 401(k) at age 30
- After 25 years at 7% interest, that $30K will have grown to $162,800
Now imagine you take out $10,000 to make a down payment on your first home.
- Your 401(k) now has $20,000 in it at age 30
- After 25 years at 7% interest, it will have grown to $108,500
- So $10,000 withdrawn now means $54,000 less in your 401(k) at retirement
This isn’t to say a 401(k) loan or withdrawal is always the worst option.
But before you turn to your retirement savings, consider all the other routes available for first-timers (or repeat buyers) to purchase a home.
Alternatives to using your 401(k) to buy a house
Many homebuyers assume they need a 20% down payment, which can make it seem nearly impossible to save enough cash to buy a new home.
But home buyers no longer need 20% down.
In fact, there’s a long list of low- and no-down-payment home loans that can lower the barrier to homeownership.
Some of the most popular low-down-payment mortgages are:
- FHA loans: allow as little as 3.5% down and only require a 580 credit score
- Conventional 97 loans: start at 3% down and require a 620+ credit score
- VA loans: available to veterans and service members with 0% down
- USDA loans: can be used in certain rural areas with 0% down
- Fannie Mae HomeReady and Freddie Mac Home Possible loans: only require 3% down and have flexible requirements for first-time home buyers who have little cash
Down payment and closing cost assistance
What if you don’t have a 3% down payment? After all, 3% of $300,000 is $9,000 — that’s still a lot of money.
If you need help making your down payment, there are other places to turn before your 401(k). For example:
- Look for down payment assistance programs in your area. DPA programs are available in every state. They offer grants and low-interest loans to help home buyers cover their down payment and closing costs. If you need help buying a house, DPA should be the first place you turn
- Look for mortgage lenders that offer down payment or closing cost help. Some lenders have special programs that offer credits to cover part of your down payment and/or closing costs. Find a few examples in our list of the best lenders for first time home buyers
- Ask a relative or family friend for help. Some home loans allow you to cover your entire down payment and closing costs using gifted money, although this must be properly documented. Make sure your real estate agent and loan officer know if you plan to use gifted funds
Most of these programs are specifically designed for first-time, lower-income, or lower-credit home buyers. So if you’re having trouble saving for a down payment for any of these reasons, there’s a good chance you could qualify.
Consider using Roth IRA withdrawals instead
If you decide to use retirement funds to help buy a home, consider using money saved in a Roth IRA instead of a 401(k) or traditional IRA. Because Roth IRA contributions have already been taxed, you’ll have an easier time accessing this money.
Also, since money in your IRA isn’t connected to your employer, you won’t face a faster repayment period if you change jobs.
Should I use 401(k) funds to avoid PMI?
Most homeowners who put less than 20% down on a conventional loan pay ongoing private mortgage insurance (PMI) to secure the loan.
You could see mortgage insurance as just another expense of owning a home — along with property taxes, homeowners insurance, and maintenance.
But since mortgage insurance protects the lender and not the borrower, many home shoppers think they must avoid PMI at any cost.
Some home buyers resort to emptying their savings accounts, pulling from their 401(k), or making IRA withdrawals to gather enough money for a 20% down payment and bypass the PMI requirement.
Does this plan really make sense in the long term?
PMI typically costs about 0.5% to 1.5% of the loan amount, annually. On a $250,000 home loan, a 1% PMI premium would add $2,500 a year — or about $208 a month — to your mortgage payment.
Yes, that’s a lot of money. But PMI also has a great return on investment. Considering the equity you’ll build through homeownership, you could see a return on investment of over 500% — all while leaving your retirement savings account untouched.
401(k) loans you behind financially while PMI does not
In the example in a previous section, we showed how removing just $10,000 from a retirement account could result in a $50,000 lower balance at retirement.
Now imagine you remove $20,000 or even $30,000 to reach the 20% down payment mark to avoid PMI. The future losses are going to be way more impactful than the $200 per month outlay now. Don’t sacrifice your retirement savings because you’re averse to PMI. Look at the long-term, broader view.
You can drop or refinance PMI
If you have a conventional loan, you can drop private mortgage insurance once you build 20% equity in your home. And servicers automatically cancel PMI once you reach 22% home equity.
If you have an FHA loan or USDA loan with permanent mortgage insurance, you could get rid of it by refinancing into a conventional loan later on.
PMI is temporary, but the effects of pulling funds from your 401(k) could have permanent consequences.
Still not sure? Ask a financial advisor
For most home buyers, withdrawing or borrowing from 401(k) retirement funds to make a down payment on a house is short-sighted. But there may be exceptions depending on the state of your personal finances and overwhelming financial need.
For some people, hardship distributions or 401(k) loans could be a sensible solution.
A financial planner can help you weigh your current account balance against your long-term financial goals so you can better decide how to proceed.
Find out if you qualify for a mortgage loan without 401(k) funds
With such a wide range of mortgage options and down payment assistance on the market, most people simply don’t need to tap their 401(k) in order to purchase a home.
Before taking money out of retirement, find out whether you qualify for a mortgage based on your current savings. You might be surprised.
The information contained on The Mortgage Reports website is for informational purposes only and is not an advertisement for products offered by Full Beaker. The views and opinions expressed herein are those of the author and do not reflect the policy or position of Full Beaker, its officers, parent, or affiliates.