401(k) plans are a popular savings option for many people as they offer a tax-deferred way to save for retirement. However, you may be considering using the funds from your 401(k) for a different purpose such as buying a house. It's a big decision for you since tapping into your retirement savings too early can negatively impact your financial future.

In this article, we will explore whether it is possible to use your 401(k) to buy a house and the potential risks and benefits of doing so. We will also provide information on alternatives you should consider before making a final decision.

What Is A 401(k) and How Does It Work?

Before deciding whether you should use your 401(k) to buy a house, it’s crucial to understand how exactly a 401(k) retirement account works.

Your 401(k) account is an earmarked savings account designed to help you prepare for retirement. According to the Internal Revenue Code of the IRS , 401(k) holders can claim a tax deduction and will see their contributions to the account accrue tax-free interest over time. However, access to the account is strictly restricted.

Withdrawals from a 401(k) should not occur before the account holder turns 59 ½ or before they turn 55 and have left or lost their job. Early withdrawals are subject to a 10% early withdrawal penalty on the amount of money taken from the account. Since the money is no longer in a protected retirement savings account, it also becomes subject to income tax.

Although these regulations may seem harsh, they are in place to encourage account holders to save enough for a comfortable retirement. However, it is not illegal to withdraw money from a 401(k) early, and those funds can serve as a down payment  on a house.

How To Use A 401(k) To Buy A House

If you decide to use your 401(k) to buy a home, you can choose from two options.

1. Obtain a 401(k) loan

One option is to obtain a 401(k) loan. You are better off with this option because not only do you avoid the 10% early withdrawal penalty, but also the amount you withdraw will not incur income tax.

A 401(k) loan has other benefits as well. It doesn’t count toward your debt-to-income ratio and will not be counted by credit bureaus. Therefore, taking out a 401(k) loan will not harm your credit score or affect your chances of getting a mortgage.

The maximum amount you can withdraw from a 401(k) loan is $50,000. It must be repaid with interest, typically between 1 – 2%. You cannot make additional contributions to your 401(k) account until you have repaid the loan. In other words, your employer won’t be matching any payments either. Taking out a loan essentially puts a freeze on your 401(k) until you have paid it off in full. Depending on how long it takes, you may miss out on years of growth.

However, not all employers offer 401(k) loans as an option in their retirement plans. It’s also important to note that you are still required to repay the loan even if you leave or lose your current job. Once that happens, the repayment period shortens, and the loan must be repaid in full by the next tax filing date.

If you can’t make this due date, the IRS will consider the loan amount a 401(k) withdrawal. As a result, you will be subject to income tax and have to pay the 10% early withdrawal penalty. For that reason, make sure your career is stable before taking out a 401(k) loan.

2. Make a 401(k) withdrawal

Another option would be to withdraw funds directly from your 401(k). As mentioned above, it is the less desirable option.

An early withdrawal would qualify as a hardship withdrawal. The IRS considers any emergency withdrawal from a 401(k) to cover “an immediate and heavy financial need” as a hardship withdrawal. Whether or not buying a home using your 401(k) counts as a hardship withdrawal is a determination that falls to your employer. You also have to show evidence of hardship to get your withdrawal approved.

However, you will still be subject to the 10% early withdrawal penalty. Exemptions are available for specific circumstances, such as home-buying expenses for a primary residence. Even so, qualifying for such exemptions can be challenging by design. A home purchase exemption is unlikely to apply if you own other assets that are suitable for the purchase. Regardless, you will still have to pay taxes on your withdrawal.

A Note About The CARES Act

As part of the response to the Coronavirus pandemic, the $2 trillion Coronavirus Aid, Relief and Economic Security Act (CARES)  emergency stimulus bill was drafted and signed into law on March 27, 2020. Under the act, 401(k) account owners can make a hardship withdrawal of up to $100,000 without being subject to the 10% penalty. The bill also grants the account holder 3 years to pay the income tax instead of the same year.

Alternatives To Using Your 401(k) For Home Purchases

Take the time to consider all your options before you tap into your retirement savings. For instance, you may want to use funds from an individual retirement account (IRA) or delay home buying until you have saved enough money.

IRAs

IRAs have special provisions for first-time homebuyers and people who haven’t owned a primary residence for the past two years.

For a first-time home purchase, you can withdraw up to $10,000 from a traditional IRA without paying a 10% penalty before age 59½. If you take a distribution from a traditional IRA that exceeds $10,000, the additional distribution amount would be subject to a 10% penalty. It also would be added to your income tax.

You can withdraw as much as you wish from your contributions to a Roth IRA with no penalties and taxes since those funds have already been taxed. However, you must have had the account for five years and must pay taxes on any withdrawals.

Delay Homebuying

Consider delaying your homebuying plans if you don't have enough cash to purchase a new home. As a result, you can spend more time saving for a down payment. The downside of delaying homebuying is the possibility that home prices or interest rates will increase.

FHA Loan

A Federal Housing Administration (FHA) loan  is a government-backed mortgage with looser requirements designed to make it easier for first-time home buyers to buy a property. It includes low down-payment options and lower credit score requirements. Therefore, an FHA loan may be better than withdrawing from your 401(k).

An FHA loan comes with a few caveats. The first step is to qualify for one. It involves your prospective home getting reviewed by an FHA-approved appraiser. You must also occupy the house within 60 days of closing the deal, and it must be your primary residence.

FHA loans also require the borrower to have mortgage insurance for the life of the loan or 11 years if you made at least a 10% down payment. Mortgage insurance for FHA loans includes an upfront premium charge of 1.75% and an annual premium ranging from 0.45% to 1.05% based on four factors:

• Mortgage term
• Loan-to-value ratio
• Total mortgage amount
• Size of your down payment

VA Loan

A Department of Veterans Affairs (VA) loan may be a better alternative than withdrawing from your 401(k) account if you are an eligible service member, veteran, or spouse.

As with FHA loans, VA loans are government-backed and include lower interest rates and more flexible terms. The one main difference is that a VA loan requires no down payment. You must meet at least one of these criteria to qualify for a VA loan:

• Served in the National Guard or Reserves for more than six years or at least 90 days under Title 32, with 30 of those days being consecutive
• During wartime, served 90 continuous days of active duty
• During peacetime, served 181 days of active duty
• Are a spouse of a service member who died in the line of duty or as a result of an injury they sustained while on active duty
• Veterans discharged because of disability are exempt from service time requirements

By demonstrating proof of service as a veteran, active member, or spouse, you can obtain a Certificate of Eligibility for a VA loan. Depending on your category, you will need different forms of proof.

FAQs

Is it a good idea to use my 401(k) to buy a house?

You might not want to use your 401(k) to buy a house for several reasons. Even if you’re comfortable with the 10% early withdrawal penalty, you will still suffer long-term consequences by reducing your savings which will damage your future growth prospects.

For instance, if you withdraw $10,000 from a $20,000 401(k) account, you will still have $10,000 that accrues interest. With a 7% annualized rate of return, $10,000 would become $54,000 after 25 years – instead of $108,000 if you had not withdrawn $10,000.

By withdrawing from your 401(k) account, you are essentially taking out a loan against yourself. You also have to pay interest if you want to repay it, and the time you spend paying it back could have been spent on growth.

What are some reasons you can withdraw from a 401(k) without penalty?

The following situations allow you to withdraw money from a 401(k) without penalties:

• An amount of medical debt that exceeds a percentage of your adjusted gross income
• A permanent disability
• A court-ordered withdrawal to compensate a former spouse or dependent
• Active duty
• Down payment for a first home
• You owe the Internal Revenue Service (IRS)
• Death of the account holder
• Income after your official withdrawal age

How much can you withdraw from your 401(k) to buy a house without penalty?

It is possible to take out a 401(k) loan for less than half your vested balance. You will accrue interest that gets credited to your account, and you will not be able to contribute until the loan is repaid.

Would it be possible to  withdraw money from my 401(k) to buy a second house?

You can withdraw money from 401(k), but you will incur an early withdrawal penalty of 10% plus taxes. There are some first-time homebuyer situations where you can avoid the penalty and taxation but not when using the funds for a second home purchase.

Bottom Line

Your 401(k) account might seem tempting as an untapped source of cash, especially if you’re struggling to come up with the money for a down payment on your new house. Although this is a viable option, and there are ways to mitigate the penalties, it should only serve as a last resort. Consider using your IRA if you have one, or apply for a low-down-payment loan like an FHA or VA loan. Whatever you decide, consult a mortgage specialist before committing to an option.