Using your 401(k) to purchase a home has pros and cons
Using your 401(k) to make a down payment on a house is typically allowed. There are even some benefits if you borrow from your 401(k): these loans aren’t taxed and come with competitive interest rates. However, doing so could cause lasting damage to your retirement savings. Read on to discover whether using your 401(k) to make a down payment is a suitable option for your situation.
Note: This article is for general informational purposes only. The Mortgage Reports is not a tax website. Check the relevant Internal Revenue Service (IRS) rules with a qualified tax professional to ensure they apply in your personal circumstances.
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Using a 401(k) to buy a new house: Allowed but not recommended
Using your 401(k) to cover the down payment and closing costs on a home purchase is possible. But you likely can’t use your 401(k) to buy a house flat-out, since there are limits to how much you can take out.
However, as most financial experts will tell you, using a 401(k) to buy a house typically isn’t the best idea.
You have plenty of alternatives to your 401(k) to get cash for a down payment. Options 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.
How to use a 401(k) to buy a house
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, you can access your 401(k) funds in two ways:
- 401(k) loan: Take a loan from your 401(k) account, which will need to be repaid with interest
- 401(k) withdrawal: 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.
1. Apply for a 401(k) loan
A 401(k) loan is the preferred method 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 (DTI). So it won’t necessarily 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 include a 401(k) loan in your DTI, even though it isn’t on your credit report,” cautions Jon Meyer, The Mortgage Reports loan expert and licensed MLO.
So be sure to speak with several loan officers to determine the best lender for your situation.
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, usually five years
- Typically, you cannot make 401(k) contributions while you have an outstanding 401(k) loan
Also, be aware that while qualified 401(k) loans are penalty-free, 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. This means it’s taxable income and subject to a 10% penalty. More on early distribution penalties next.
2. Make a 401(k) withdrawal
Using a 401(k) withdrawal to buy a house is generally not recommended 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, 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
- 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 from your retirement savings on top of the initial withdrawal.
The standard 401(k) withdrawal rules 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.
The IRS does have exemptions for early withdrawals that are considered a hardship. This means you wouldn’t have to pay a 10% penalty for tapping your 401(k) in certain circumstances. However, you must provide proof of “an immediate and heavy financial need.” For most first-time buyers, not having enough money for a down payment will not qualify.
Nonetheless, if your situation falls under a hardship exemption, speaking with a tax professional is a good first step.
Is it a good idea to use my 401(k) to buy a house?
For many homebuyers, there are too many downsides to using a 401(k) to buy a house.
For example, while you’re repaying the 401(k) loan, you usually can’t make new contributions to your retirement account. That also means your employer won’t be matching contributions.
You could miss out on several years of retirement contributions and compound interest on those funds. This will likely make a big dent in your savings later in life.
Alternatives to using your 401(k) to buy a house
Before tapping your 401(k) retirement saving account, it’s important to consider all of your options. Coming up with the down payment to purchase a home can be challenging, especially in real estate markets with rising home price inflation.
Indeed, many home buyers assume they need a 20% down payment. This can make saving enough cash to buy a new home seem nearly impossible. But home buyers no longer need 20% down with the wide variety of home loan options available today.
1. Consider a low-down-payment mortgage
Mortgage lenders now offer a long list of low- and no-down-payment loans which can lower the barrier to homeownership.
Some of the most popular low-down-payment mortgages are:
- Conventional 97 loans: This loan type requires a minimum credit score of 620 and down payments start at 3%. But you’ll pay private mortgage insurance (PMI) with less than 20% down until you pay off 20% of the loan
- FHA loans: Backed by the Federal Housing Administration, this loan option allows as little as 3.5% down and only requires a 580 credit score. Although, you’re on the hook for mortgage insurance premiums (MIP) until the loan is paid or refinanced
- VA loans: Guaranteed by the Department of Veterans Affairs, this loan type is available to veterans and service members with no down payment whatsoever
- USDA loans: Another no-down-payment loan option, these mortgages can be used in certain rural areas
- Fannie Mae HomeReady and Freddie Mac Home Possible loans: These loan types only require 3% down and have flexible requirements for first-time home buyers with little cash
2. Apply for a down payment assistance program
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 for first-time buyers.
If you need help making your down payment, there are other places to turn before tapping 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 down payment and closing costs. If you need help buying a house, DPA should be the first place you turn
- Seek 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.
- Ask a relative or family friend for help. Some home loans allow you to cover the 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 down payment loan 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.
3. Use a Roth IRA withdrawal 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 and earnings have already been taxed, you can make withdrawals tax-free.
Also, since money in your IRA isn’t connected to your employer, you won’t face a faster repayment period if you change jobs.
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 to decide how to proceed.
FAQ: Using a 401(k) to buy a house
You can use up to 50 percent of your 401(k) balance or up to $50,000, whichever is less, when using a 401(k) loan to purchase a home. However, you can use your entire 401(k) to buy a house if you make an early distribution withdrawal. But you’ll pay a hefty 10 percent penalty fee and income tax on whatever amount you withdraw.
Yes, you can use your 401(k) to buy a house without penalty, provided you use a 401(k) loan rather than a withdrawal. Unlike a 401(k) withdrawal, a 401(k) loan is not subject to a 10 percent early distribution penalty from the IRS. The money you receive will not be taxed as income. Also, 401(k) loans typically must be paid back over five years. However, when the money is used to purchase a home, you’re usually allowed to pay a 401(k) loan back over a longer time period. Rules vary by company, so check with yours to learn more.
Yes, first-time home buyers can use their 401(k) to buy a house, but it’s 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 reduce your savings when you’re ready to retire.
Yes, you can withdraw money from your 401(k) to buy a second house, but you will be charged a 10 percent early withdrawal penalty and pay state and federal taxes on the amount taken out. Before you turn to your retirement savings, consider all the other routes available for homeowners to purchase a second home.
You probably shouldn’t use your 401(k) to avoid private mortgage insurance because the future losses outweigh the immediate gain. PMI typically costs about 0.5 to 1.5 percent of the loan amount, annually. On a $250,000 home loan, a 1 percent PMI premium would add $2,500 a year — or about $208 a month — to your mortgage payment. While that is a lot of money, withdrawing just $10,000 from your 401(k) account could result in a $50,000 lower balance at retirement.
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 don’t need to tap their 401(k) to purchase their first home. So before taking money out of your retirement savings account, find out whether you qualify for a mortgage based on your current savings. You might be surprised.