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Can You Use Your 401(k) to Buy a House Without Being Penalized?
Dreaming of owning your first home? With the rising costs of real estate, saving up for a down payment can be a daunting task.
You usually need at least 3% to 5% for a down payment and an extra 3% to 5% to cover closing costs. With the average home sale price nearing $490,000, potential buyers often need close to $50,000 or more set aside to buy a house.
But what if there was a way to tap into your retirement savings to help make that dream a reality?
Well, it can be done. You can borrow or withdraw money from your 401(k) to buy a house. But most experts say it isn’t a great idea.
We’ll explore the ins and outs of using retirement accounts to pay for a first home, including the tax rules governing 401(k)s, traditional IRAs and Roth IRAs. We’ll also delve into the pros and cons of making an early withdrawal from your retirement.
Got $1,000 in checking? These smart moves could help you reach your next big savings goal.
Before we dive into how to withdraw money from your retirement account to buy a house — and if that’s even a good idea — let’s recap what normally happens when you take money out of a retirement account before age 59.5.
Just to clarify: Contributions are money you deposited into your Roth account. So if you deposited $25,000 into a Roth IRA and the total is now $30,000 because of investment gains within the account, you can withdraw $25,000 tax free.
Yes, you can technically use your 401(k) to buy a house, but withdrawing that money comes at a high cost.
Those same 401(k) withdrawal rules apply. You’ll owe a 10% early withdrawal penalty to the IRS if you access funds before age 59.5 and you’ll also owe income taxes on the full amount you take out.
There are a few situations in which you can withdraw money from your 401(k) prior to retirement without incurring the 10% penalty. Unfortunately, buying a home isn’t one of them.
Buying a home is getting harder for the average American. If you’re considering using your 401(k) to buy a home, here are the benefits.
Using your retirement savings to purchase your first home may be a viable option under certain circumstances. But in general, it’s a bad deal.
“You’ll be taking out money that won’t grow tax-free into the future,” said Tara Unverzagt, a financial advisor at South Bay Financial Partners. “So your cost today is low, but your opportunity cost is high.”
If you want to use your 401(k) to buy a house, you’ll pay dearly to access that money. But IRAs are a different story.
Under an IRS exception, first-time homebuyers can withdraw up to $10,000 from a traditional IRA or Roth IRA without incurring the 10% penalty, so long as the funds are used within 120 days to acquire, build or rebuild a first home. You’re considered a first-time homebuyer if you haven’t owned a primary residence in the last two years.
Simple IRAs and SEP IRAs — two self-employed retirement plans — also waive the 10% penalty for first-time home buyers who meet the above criteria.
But this is important. Even though you can avoid the 10% penalty, you’ll still owe income taxes on the amount you withdraw from a traditional IRA.
For example, let’s imagine you take a qualified $10,000 distribution from your traditional IRA for a first-time home purchase.
If you’re in the 22% tax bracket, for example, you’ll need to come up with another $2,200 to pay taxes on that withdrawal when tax time rolls around.
Because you can withdraw contributions from your Roth IRA penalty-free, you won’t be subject to taxes if you use the withdrawal (up to a $10,000 lifetime maximum) to pay for a first-time home purchase.
The caveat is that if the account is less than five years old and you decide to withdraw earnings, you’ll have to pay income taxes on those.
“You need to make sure you’re distributing only contribution dollars and not any interest, dividends or capital gains, and you’ll pay no taxes on a Roth IRA distribution,” Unverzagt said.
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If your employer allows it, you may be able to take a loan from your 401(k) account. Similar retirement plans, including 403(b) and 457(b) plans, may offer loans as well.
The IRS permits loans of up to 50% of your vested account balance or $50,000, whichever is less. Repayment terms vary, but generally, you have five years to repay the loan.
There’s a few benefits to borrowing money from your 401(k) instead of taking an early distribution:
That’s why some experts say taking a 401(k) loan is a better move for first-time homebuyers than taking an early withdrawal.
“Especially if you’re buying a new home first, then selling your old home,” said Dan Murphy, a financial planner and founder of Greater Good Financial. “That way, the 401(k) loan is just a temporary loan until your current house is sold and the funds are available.
“In the end, if you’re able to get your dream home and all it costs is some interest from a temporary 401(k) loan, I think it’s a wise financial decision.”
These perks don’t mean 401(k) loans are a perfect solution for everyone in every situation.
Some drawbacks of 401(k) loans include:
“I haven’t found a good reason to borrow from a retirement account to buy a house,” said Jarrod Sandra, a certified financial planner and owner of Chisholm Wealth Management. “Saving up for a down payment is much better as it keeps your retirement dollars invested for the long run.”
Alvin Carlos, a certified financial planner and managing partner at District Capital Management, said that taking a 401(k) loan can make sense if all these of these factors apply:
“If you have a 20% down payment, your offer becomes more competitive and you avoid paying mortgage insurance,” Carlos told The Penny Hoarder. “The savings are enough to offset the opportunity cost of borrowing from your 401(k).”
However, Carlos emphasized that some companies require you to pay off the full 401(k) balance if you resign or get fired.
“This is a huge risk,” Carlos said. “It can only be mitigated if you feel confident that your job is secure.”
Pulling together enough money for a down payment can be tough. If you want to avoid tapping your retirement accounts to pay for a home, here are some alternatives to consider.
If you’re not planning to buy a home immediately, reduce your monthly expenses now and put the savings into a high-interest online savings account.
Check out our tips for cutting costs on groceries, car insurance and utilities, as well as our advice on several side gigs you can work to earn some extra cash.
FHA loans are government-backed loans that might be an option for lower-income buyers or people with lower credit scores.
An FHA loan allows you to have a credit score as low as 580, and you can also make a down payment as low as 3.5%, making these loans attractive for first-time homebuyers.
We get it. Everything is more expensive than it used to be, but your paycheck hasn’t kept up.
When money is tight, these resources will help nearly everyone.
The government offers two other down payment assistance programs to certain groups.
VA loans are available for military service members and veterans. These loans are backed by the Department of Veteran Affairs. VA loans require no down payment or mortgage insurance. However, you’ll still need to pay a VA funding fee that changes annually.
USDA loans are backed by the U.S. Department of Agriculture and are mainly for rural borrowers who can’t qualify for traditional loans. No down payment is required, although there are income and property value limits.
On the lending side, some major banks offer grants and assistance programs, such as zero-down mortgages, for buyers in specific communities.
Rachel Christian is a Certified Educator in Personal Finance and a senior writer at The Penny Hoarder. She covers retirement, investing, taxes and life insurance.
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