UPDATED: Apr 2, 2024
Buying a home comes with a significant upfront cost, and it can be tempting to use the money you’ve already built up in your 401(k) plan or other retirement accounts. The good news is that you can use your 401(k) to buy a house. However, doing so also comes with some significant downsides, and financial experts generally recommend against doing so.
If you’re considering using your 401(k) to buy a home, it’s important to understand how it works and what penalties you may face. Keep reading to learn more.
The money in your 401(k) account is yours, and you can technically use it for any purpose, including buying a home. However, that doesn’t mean it’s a good idea to do so. In fact, most financial experts would strongly advise against using your 401(k) plan to buy a home.
First, 401(k) withdrawals are subject to income taxes. Additionally, you’ll pay an additional 10% penalty tax on any withdrawal made before age 59 ½ that doesn’t meet certain exceptions. As a result, the amount of money you’ll be able to put toward your home purchase will be significantly less than the amount you withdrew from your 401(k).
On the other hand, some people may feel that using their 401(k) to buy a home is their only choice. Financial decisions are highly personal, and the right decision for some isn’t necessarily the right decision for all. If you don’t feel that you’ll be able to save for a down payment in a reasonable amount of time or you want a larger down payment to avoid private mortgage insurance (PMI) or lower your interest rate, you may decide that using your 401(k) is the right call.
There are two ways to use your 401(k) to buy a house: an early withdrawal and a 401(k) loan. The right decision for you will depend on your company’s policies, the amount of money you need, your ability to repay a loan and other factors.
First, you can withdraw money from your 401(k) to buy a home, using the money for your down payment and closing costs. If you’re at least 59 ½, you can do so without any penalties. However, if you’re younger than 59 ½, your withdrawal will be subject to a penalty tax, and that’s on top of the ordinary income taxes you’ll owe.
While an early withdrawal has some clear financial downsides, it also has a major benefit: you don’t have to pay back the money.
Many 401(k) plans allow employees to take loans from their accounts. It’s up to each company whether to allow loans. If your 401(k) plan allows loans, you can borrow up to 50% of your vested balance or $50,000, whichever is lower.
401(k) plans can have some strict rules. Loans are dictated by a company summary plan description. This document outlines when and how long an employee can take out a loan.
It’s important to note, if you leave your job – this applies whether you’re fired or leave of your own accord – you’ll have to repay the entire loan right away.
As we’ve mentioned, withdrawing money from your 401(k) has some serious tax implications. First, any withdrawal from a traditional 401(k), even during retirement, is subject to ordinary income taxes. Tax rates range from 10% – 37%, depending on your taxable income.
Additionally, the IRS imposes an additional 10% early withdrawal penalty on any 401(k) withdrawals before age 59 ½ that don’t meet certain exceptions.
Let’s say you decide to withdraw $50,000 to buy a house. For the purpose of this example, let’s assume you have a tax rate of 22%. Right off the bat, you’ll pay 22% of your withdrawal, or $11,000, in income taxes. You’ll also pay the early withdrawal penalty of 10%, which comes to $5,000.
Though you initially withdrew $50,000 from your 401(k), you only have $34,000 left for your home purchase.
Taxes aren’t the only potential cost of using your 401(k) to buy a house. First, if you take a loan from your 401(k), you’ll have to pay interest, just as you would any other loan. This type of loan is unique since you’re both the borrower and the lender of the loan. As a result, the interest you pay goes back into your 401(k) with the principal balance. However, it does represent an added cost of the loan right now.
Finally, perhaps the most important cost of withdrawing money from your 401(k) is the money you’ll lose out on for retirement. The money in your 401(k) is invested, allowing it to grow and compound for the future. But once you withdraw a chunk of it, it isn’t able to compound as much. And in the end, you retire with less money.
Let’s go back to our example of a $50,000 withdrawal to buy a house. $50,000 doesn’t sound like it would make that big of a difference during retirement. But what about when you consider what that $50,000 could turn into?
Let’s say you’re 35 when you’re buying a house and you plan to retire at 65. If you had left that $50,000 in your 401(k) and had an annual return of 10% – that’s the average, according to the U.S. Securities and Exchange Commission – it would have turned into $872,470. Suddenly, that $50,000 doesn’t seem like such an inconsequential amount of money.
Whether you’re considering a 401(k) loan or an early withdrawal to buy a home, there are some pros and cons to consider.
A 401(k) isn’t your only option when it comes to funding your home purchase. Here are a few alternatives to consider:
Before using your 401(k) to buy a house, consider reading these frequently asked questions.
Unfortunately, there’s no exemption that allows you to take a penalty-free withdrawal from your 401(k). However, you can withdraw up to $10,000 from an IRA with no penalties to purchase your first home.
You might be able to use a 401(k) loan to buy a second home, but only if your plan allows loans. It's worth noting that hardship withdrawals from 401(k) accounts are usually meant for primary residences. Also, keep in mind that some plans restrict the number of loans you can take out at once, so it's essential to check your plan's rules beforehand.
You can avoid the 10% penalty on an early withdrawal from your 401(k) by taking it as a loan rather than a withdrawal. In that case, you’ll have to repay the full amount with interest. The only other way to avoid the 10% additional tax is to wait until age 59 ½ or until you reach one of the other penalty exemptions.
Unlike other types of loans, a 401(k) loan doesn’t affect your credit. You won’t need to go through a credit check to qualify for the loan, and it won’t negatively affect your credit if you don’t repay the loan.
Taking money from your 401(k) is one of the money options available to help you fund your home purchase. However, it shouldn't be the first place you turn. Not only will an early 401(k) withdrawal result in costly taxes and penalties, but you’ll also be robbing your future self of money during retirement.
If you’re preparing to buy a home, whether you’re using your 401(k) or another funding source, start an online application and see what options you have today.
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