Employee-sponsored retirement funds have provisions that allow homebuyers to use their savings on a new residence — but it can come with trade-offs.
Before using a 401(k) to buy a house, every buyer should consider the decision carefully. For example, do you understand the tax implications of a 401(k) withdrawal or loan? And do you know how long would it take for you to recover the hit to your long-term savings?
It’s important to learn about the rules, the pros and cons, and alternative options to dipping into your 401(k) to buy a home.
- There are different ways to use your 401(k) to buy a house, such as drawing from your savings or taking out a loan.
- It’s important to understand how your 401(k) works before using the funds to purchase a home.
- Given the pros and cons of using your 401(k) to buy a home, you also should consider alternative options.
Using 401(k) Retirement Funds To Buy a Home: Is It Allowed?
In simple terms, using a 401(k) to buy a house is allowed under IRS rules. However, there are specific situations on when, how, and which types of 401(k) accounts can be used toward your next home.
For example, if you plan on taking out a loan from your retirement account, the money can only come from qualified accounts, including 401(k) plans. You can’t take a loan from individual retirement accounts, including self-employed pension plans and SIMPLE IRA plans.
In addition, making a 401(k) withdrawal for a home purchase comes with certain tax implications. Any money removed from a retirement account for a home purchase cannot be paid back to the plan or rolled over into a new IRA.
Different Ways To Use Your 401(k) To Buy a House
There are two primary ways to make a 401(k) withdrawal for a home purchase. One option is to take a straight withdrawal from the account, known as a hardship distribution. The other is to take a loan from the account, provided by the plan sponsor.
Drawing from your 401(k) for a down payment or closing costs
Some 401(k) plans allow account holders to take a 401(k) withdrawal for home purchases. Start by working with your company’s human resources department to determine if early distributions are allowed.
You may be required to provide proof that you need the hardship distribution. This is a written statement explaining that you cannot get the funds from other sources, such as insurance payouts, paychecks without elective deferrals or after-tax contributions, or other loans.
If your plan offers a hardship distribution option, the request must meet two requirements:
- The hardship distribution is for an “immediate and heavy financial need.”
- The amount withdrawn from the account is limited to just what is necessary.
The good news is that under IRS safe harbor rules, costs directly related to the purchase of a principal residence —excluding mortgage payments — count as an immediate and heavy financial need. This may include making your down payment or paying closing costs.
While drawing on your 401(k) to buy a home is possible, you can’t use it as a first resort or withdraw more than you need. For example, if you received a gift from family to purchase your home, or have savings or investment accounts, you must use those sources before taking a hardship distribution.
Using a 401(k) to buy a house may come with tax implications as well. Qualified first-time homebuyers can take up to $10,000 from their retirement account without paying the 10% early distribution tax. Taking more than $10,000, or using your 401(k) funds to leave your current home to buy a new one, will trigger the tax.
Taking a loan from your 401(k)
Another option for using a 401(k) to buy a house is taking a loan from your retirement savings. A 401(k) loan borrows from your retirement to put money toward your next home.
“When you take a loan from your 401(k), you are essentially borrowing from yourself,” says Eric Hallin, a financial advisor and principal of Oak & Vine Wealth Management in Paso Robles, California. “You do not need to undergo a credit check, and there is no requirement for a down payment. But you will need to pay back the loan with interest.”
Just like with a hardship distribution, your employer must allow you to borrow from your 401(k). Not all employers allow borrowing from your retirement plan, so your first step should always be to check with your human resources department to see if it’s possible.
Your employer or retirement plan administrator can provide information about the process, including:
- The minimum and maximum 401(k) loan amount allowable.
- How many years you’ll have to repay the loan, and the interest rate.
- Loan repayment options.
- Loan security options, where required.
- Spousal consent requirements, where applicable.
The maximum loan you can borrow is 50% of your vested account balance, or $50,000 — whichever is the lesser amount. For example, if the vested balance on your 401(k) is $20,000, then your maximum allowable loan is $10,000. But if the balance is $125,000, then the maximum is $50,000, because it’s less than 50% of your vested account balance.
If you decide to take more than the maximum loan amount, the excess will be considered a “deemed distribution” and subject to the 10% early distribution tax.
If you’re taking a 401(k) loan for the purchase of a primary residence, you may have extra time to pay down the loan. While IRS rules require most 401(k) loans to be repaid in five years, loans to purchase a primary residence are an exception. But if you stop making payments on at least a quarterly basis, the remainder of the loan may be converted to a distribution — leaving you to pay the 10% early distribution tax on the balance.
The key advantage of a 401(k) loan is that it doesn’t get reported to the credit bureaus. Because you’re borrowing from money dedicated to your future, it won’t count against your debt-to-income ratio or result in a temporary reduction of your credit score.
At the same time, there are serious downsides to consider. If you leave your job while repaying the loan, your former employer may require you to repay the balance immediately. And if you’re unable to roll over the loan into an IRA, the employer can treat the unpaid balance as a distribution subject to taxes.
Another complication could be spousal consent requirements. Certain plans require your spouse’s permission if the loan is above $5,000.
How a 401(k) Works
A 401(k) is one of several qualified plans that allow W-2 employees to dedicate some of their wages to retirement on a pretax basis, which is called an elective deferral. These elective deferrals and any resulting investment gains aren’t subject to federal income tax until withdrawn. Depending on the 401(k) plan you’re invested in, you can contribute between $15,500 and $22,500 every year.
As part of a profit-sharing agreement, your employer may offer to match your retirement investment — up to a certain amount — each pay period. Although you’re always fully vested in your savings, your employer may require you to stay employed for a certain amount of time before you’re fully vested in their contributions.
Withdrawals from your 401(k) are allowed when you meet one of three requirements:
- You decide to retire after you reach 59 1/2 years old.
- You die or become disabled.
- The plan is terminated, and no successor is determined by either the account holder or the employer.
If you leave your job, you don’t have to withdraw the money in your 401(k). You can roll it over into another 401(k), an IRA, or another retirement account within 60 days. If you decide to do this, you may not be required to pay taxes on the money.
Restrictions on drawing from your 401(k)
Because 401(k) plans are meant to help you save for retirement, the IRS taxes anything you take out of it before you reach 59 1/2 years old. If you decide to take out cash for anything other than a qualified exception, your withdrawals will be subject to both income tax and a 10% early distribution tax.
If you’re withdrawing from a Roth 401(k) account or taking a hardship distribution, there may be exceptions to the early distribution tax.
With a Roth 401(k), your contributions are taxable but won’t be subject to additional taxes once you start taking qualified distributions from your account. So, can you use your Roth 401(k) to buy a house?
Much like with a traditional 401(k) account, you can make a qualified hardship distribution from your Roth 401(k) if it has been open for at least five years. The same rules apply, except a withdrawal from a Roth 401(k) doesn’t count toward your gross income that year, because you already paid taxes on the money. However, any earnings from investments are taxable.
Specific life circumstances
Some plans may allow you to take a hardship distribution for qualified reasons. These include:
- Medical care expenses for the employee, their spouse, or eligible dependents.
- Tuition and educational expenses for the employee, their spouse, or eligible dependents.
- Funeral expenses.
- Certain home repair expenses that would qualify under the casualty deduction.
Your hardship distribution may not be subject to the 10% early distribution tax. Before taking any money out of your retirement plan, be sure to check with the IRS to determine if you qualify for tax exceptions.
How To Use Your 401(k) To Buy a House
The first step when deciding if you should use your 401(k) to buy a house is to talk with a financial advisor about whether a hardship distribution or a loan is right for your needs.
The next step is to check with your company’s human resources department to see if its retirement plan offers either option. While many plans allow employees to take a loan or a 401(k) withdrawal for a home purchase, they aren’t legally required to.
Once you’ve met with a financial advisor and your human resources department, you’ll need to decide how much of your 401(k) you want to use. As mentioned, a hardship distribution is limited to the amount required to cover your down payment and closing costs, and a loan is limited to the lesser of 50% of your vested account balance or $50,000.
After understanding your options and collecting documentation to support your claim, you’ll be ready to apply for either a 401(k) loan or a hardship distribution. Each fund management company has a different application process, which can be explained by a representative or your human resources department.
Pros and Cons of Using a 401(k) To Buy a House
Before you decide to use your 401(k) plan to purchase a home, consider the pros and cons.
Benefits of using a 401(k) to buy a house
- You won’t have to get third-party approval. Borrowing or withdrawing from your 401(k) account is just taking your retirement money early, so you won’t need approval from a lender.
- You can access the funds quickly. While it can take weeks to get money from a traditional loan, taking a hardship distribution or borrowing from your 401(k) is a relatively fast process. In some cases, you can receive funds within three to five days of your application.
- You may receive better terms. In some situations, you could get better repayment terms or a tax break by using your 401(k) instead of a second mortgage. For example, if you’re using a 401(k) as a first-time homebuyer, you may qualify for a $10,000 exception from the early distribution tax. And if you’re borrowing from your 401(k), you may be exempt from the five-year payback requirement if it’s for your primary residence.
- You avoid a hit to your credit score. A 401(k) loan for a home purchase is borrowed money from yourself. Because you aren’t borrowing from a bank or other lender, you won’t need to go through a credit check. This can help you optimize your credit score before closing.
- Defaulting might not affect your credit. If you’re unable to repay your 401(k) loan for a home purchase, it might not show up on your credit report as a delinquent account. Most 401(k) loans in default are written off as a disbursement, subject to the 10% early distribution tax.
- You may be able to secure a lower mortgage rate. Whether it’s from reducing damage to your credit score or using your retirement savings to purchase discount points from your lender, using a 401(k) to buy a house could help you lower your interest rate, which can save you a significant amount of money over the life of your mortgage.
Drawbacks of using a 401(k) to buy a house
- There could be a 10% penalty. If you don’t pay back your 401(k) loan for a home purchase, or if you take too much money out of your retirement fund as a hardship distribution, then the amount may be subject to a 10% early distribution tax at the end of the year.
- It reduces your retirement savings. “One of the primary disadvantages of using a 401(k) to buy a house is that you are tapping into your retirement savings, which could have a significant impact on your long-term financial security,” Hallin says. “While this can be a helpful way to finance a home purchase, it also means that you are reducing the amount of money that you have saved for retirement.”
- It limits the growth of your savings. As you grow your retirement account, your savings will accumulate compound interest, or the interest earned on interest. Taking money out of your 401(k) means you lose opportunities for compound interest to work its magic.
- Older plans might not qualify. Retirement plans don’t need to allow for loans and hardship distributions. Before you start banking on using your 401(k) to buy a house, be sure to check your plan documents to see if those options are even available.
Alternatives To Using Your 401(k) To Buy a House
If using your 401(k) to buy a house isn’t the right move for you, there are alternatives to consider.
If you find yourself short of your down payment savings goal, it might not be the right time to make a home purchase. Instead, it may be wise to keep saving until you can afford a down payment and closing costs without dipping into your retirement.
Draw from your IRA
Many Americans have some retirement savings in an IRA. If you’re short of your homebuying goal, you could draw from your IRA without needing to show proof of hardship.
There are three key downsides to drawing from an IRA. First, you cannot take a loan from an IRA — only distributions are allowed. Second, all distributions are subject to income tax and the 10% early distribution tax if you’re under 59 1/2 years old. Finally, it will reduce your retirement savings, which could lose long-term value from compound interest even if you replace the money eventually.
Explore loans with low down payment requirements
Instead of using your 401(k) to buy a house, you can see if you qualify for a loan program with low down payment requirements, such as:
- FHA loans. Insured by the Federal Housing Administration, FHA loans are available to most homebuyers and only require a 3.5% down payment.
- VA loans. Only available to eligible service members, veterans, and their surviving spouses, VA loans offer a zero down payment option and loans with no mortgage insurance premiums.
- USDA loans. USDA loans are available with zero money down for low-income applicants living in qualifying rural areas.
Research down payment assistance programs
Many state, regional, and city governments and nonprofit organizations offer down payment assistance programs for first-time homebuyers.
Should I Use My 401(k) To Buy a House?
The decision to use your 401(k) to buy a house shouldn’t be taken lightly. It’s important to carefully weigh the pros and cons. The biggest question is whether the benefits will outweigh the hit to your retirement savings.
“In general, it is advisable to explore other financing options before tapping into your retirement savings, as this could have significant consequences for your long-term financial security,” Hallin says. “However, it is important to discuss your options with a financial advisor and loan officer to determine the best course of action.”
FAQ: Using a 401(k) To Buy a Home
Here are the answers to frequently asked questions about using 401(k) retirement savings to purchase a home.
Using a 401(k) to buy a house comes with limitations. You can’t use a hardship distribution to pay off a government loan, because it’s limited to the specific amount you need for your down payment and closing costs. You could potentially use a 401(k) loan to pay off a government loan, but you can only borrow the lesser of $50,000 or 50% of your vested account balance, and must repay your plan on a quarterly basis.
Not necessarily. The amount you can borrow or draw from your 401(k) may not be enough to cover the purchase price of a home. Moreover, income tax and the 10% early distribution tax could make using a 401(k) to buy a house more expensive than saving money or seeking out a down payment assistance program.
The Bottom Line on Using Your 401(k) To Buy a House
Although your 401(k) is designed to benefit you in your golden years, those savings can help get you in a home today. But before you start looking at a 401(k) loan or a hardship distribution, it’s important to do your research. Understanding how much you can use, how it may affect your taxes, and the long-term gains or drawbacks will guide your decision on whether this is the best way to afford your new home — or if exploring other options is better.