Using Your 401(k) to Buy a House: Pros, Cons, and Key Considerations

Homeownership is a great challenge to undertake. The full extent of this challenge becomes clear only when you face it head-on. Owning a new home requires significant savings for a down payment.

If your savings are not enough, it does not mean you have to abandon your dream of owning a home. From tax breaks to employer matches and high contribution limits, there are several reasons why people choose 401(k) as the best retirement savings tool. You might consider using funds in your 401(k) retirement plan by taking a withdrawal or loan.

While accessing money and using 401k to buy a house may seem straightforward, each option has pros, cons, and important considerations.

Continue reading to discover the best ways to utilize your 401(k) to buy a house.

How a 401(k) Can Be Used for a Home Purchase

You may have heard that you can withdraw funds from your 401(k) for the first time for a down payment without repercussions. However, that is not true. The IRS rules for 401(k) withdrawals state “costs relating to the purchase of a principal residence” as a type of “hardship withdrawal.” Such a type of withdrawal is usually exempt from the 10% penalty. 

While the IRS acknowledges residence costs as a hardship withdrawal, it is not exempt from the 10% additional tax when taken from a 401(k). You can withdraw money, but not without a penalty. Even if there are no penalties based on the rules set by your employer, the withdrawn funds will be subject to income tax.

• 401(k) Loans

You can borrow $10,000 or half your vested account balance or $50,000. 401 (k) loans neither incur a penalty nor have to worry about income tax on the borrowed amount. Interest on the borrowed amount is all you have to worry about.

The interest rate and other repayment terms on the borrowed amount can vary from one plan provider to another. However, you must remember that the loan terms usually do not exceed 5 years. 

Returning a 401(k) loan is almost like repaying yourself but without a tax break or an employer match. Your loan payments are not counted as contributions to your 401(k). Your plan provider may not let you make contributions to the 401(k) before you repay the loan either.

• 401(k) Withdrawals

Depending on the terms decided by your plan provider, you may not have an option for 401(k) loans. This limitation only leaves you with the choice of withdrawing from the account. This withdrawal will come with a penalty of 10% with income taxes. 

If you are comfortable with penalties and taxation, you can make outright withdrawals and leave replenishing your 401(k) account for later. You must remember that even without any penalties, any earnings would be subject to taxation.

Pros and Cons of Using Your 401(k) for a Home Purchase

A 401(k) makes saving for retirement and reducing tax burden side-by-side possible. However, the benefits of 401(k) do not come without a charge. You must talk to a financial professional who can walk you through your options and better understand the pros and cons of using your 401(k) to buy a house.

Advantages of 401k to Buy a House

Here are some of the advantages of using 401(k) funds.

Access to Funds

People who need quick access to a large sum of money can rely on their 401(k) accounts, especially when they do not have any funds in their savings account. This way, aspiring first-time home buyers can have a chance to find their dream home instead of waiting for years to accumulate enough down payment.

Potential to Avoid PMI

You can also avoid the cost of private mortgage insurance (PMI) if you use your 401(k) funds for a larger down payment. It can lower your monthly payments and reduce the overall cost of the mortgage/ this way; first-time homeownership can become financially manageable.

Faster Down Payment Accumulation

People often keep delaying fulfilling their dream of buying a home because of their inability to save for a down payment. Instead of waiting for years to come up with the total amount for a down payment, you can use your retirement savings to make a competitive offer.

 Disadvantages of Using 401k to Buy a House

Here are some disadvantages of 401(k) funds to consider

Penalties

People under 59½ years old face a 10% early withdrawal penalty on withdrawals. This number can decrease the total amount of money you have and make it a less appealing option to consider for aspiring homeowners.

Taxes

Any funds withdrawn from a 401(k) are subject to income tax at your current tax rate. This means that the net amount you have will be reduced even further due to taxes. Hence, you must be prepared for hefty taxes.

Loss of Compounding Growth

Withdrawing money and using 401k to buy a house can also lead to loss of opportunity through compounding. Retirement accounts are designed to benefit from years of investment growth, and removing funds can significantly impact your retirement savings. 

Increased Financial Risk

From the housing market experiencing a downturn to an addition in mortgage, several risks are involved in becoming a first-time homeowner that you must be prepared for. You must keep a backup plan in mind to navigate financial difficulties moving ahead.

Long-Term Impact on Your Retirement Savings

Turning to your retirement account for something as significant as your dream home can sound like a wonderful idea. If you are thinking of doing the same, you must take a pause and see how this step can hurt your financial well-being in the long run.

Tax Implications of 401(k) Withdrawals for Home Buying

If you fail to take the required minimum distribution, the Internal Revenue Service (IRS) can impose a penalty of 25% on the amount not distributed. However, this penalty may be reduced to 10% if you take corrective distributions and meet certain requirements. 

Here is everything you need to know about federal penalties and taxes related to early withdrawals.

State-by-State Tax Variations 

Tax implications for using 401(k) funds to buy a house vary significantly from one state to another. While federal taxes and a 10% early withdrawal penalty typically apply for those under age 59½, states like Florida, Texas, and Washington allow withdrawals without additional state-level taxation. 

In addition, high-tax states like California and New York impose substantial state income taxes on these withdrawals. On the contrary, Pennsylvania and Mississippi are entirely exempt from retirement income. 

Exploring Alternatives to Using a 401(k)

A 401(k) isn’t the only option to consider when trying to afford your dream house. You can also explore alternative ways to manage your finances before making the significant decision to buy your dream home.

IRA Withdrawals

First-time homebuyers are allowed penalty-free withdrawals of up to $10,000. If you are younger than 59 ½, you will owe them 10% of the amount you withdraw. These funds can help you expedite the process of becoming a homeowner.

Other Mortgage Programs

First-time homebuyers can explore FHA, VA, and USDA loans. FHA loans require just 3.5% down, VA loans have no down payment for veterans, and USDA loans, for rural buyers, also allow no down payment. Each option has unique benefits to aid homeownership.

Home Equity Loans and Other Sources

Home equity loans and other funding sources are excellent options that enable homeowners to borrow against the equity built up in their homes. Borrowers receive the funds as a lump sum and make fixed payments over time. In addition, first-time buyers can consider personal loans to cover their expenses.

Comparing 401(k), IRA, and Mortgage Loans

Here is a comparison table covering the pros, cons, eligibility, withdrawal penalties, and flexibility of each option.

Step-by-Step Guide for First-Time Homebuyers Accessing 401(k) Funds

Here is a step-by-step guide you need to be able to access 401(k) loans and withdrawals and expedite the process of becoming a first-time homeowner.

Step 1: Determine Eligibility

To determine your eligibility for 401(k) loans and withdrawals, you should first check if you meet certain criteria. Typically, you must be an active participant in the plan and have a vested account balance. The maximum amount you can borrow is generally the lesser of $50,000 or 50% of your vested account balance.

Step 2: Assess Financial Impact

If you are eligible, the next important thing to figure out is the financial impact of a loan or withdrawal from your 401(k) account. You can easily estimate the financial impact by consulting a financial advisor or using a retirement calculator at home. Get in Touch with a Financial Advisor to Explore Your Options

Step 3: Evaluate Alternatives First

401(k) can seem like the fastest and most reliable option to get your finances to be able to buy your home. However, you must not rush into making decisions. Instead, it is always best to explore other options before committing to a 401(k).

Step 4: Initiate the withdrawal or loan process

Once you have chosen a loan or hardship withdrawal, work with your plan administrator to submit the necessary forms. You may need to provide documentation proving the funds are for purchasing a primary residence for hardship withdrawals. 

FAQs on Using Your 401(k) to Buy a House

Can I try Using 401k to buy a house without penalty?

People are allowed to withdraw money using 401k to buy a house for hardships such as medical debt, college tuition, etc. Your chances of facing a penalty are based on your employer’s specific plan. 

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

People considering borrowing money from your 401(k) for a house must consider that they will not only be incurring the 10% penalty for withdrawal but also compromise their retirement savings in the long run.

Can I use my 401(k) for a down payment on a house?

Yes, you can use your 401(k) for the down payment on your home after reviewing your provider’s terms. However, you must consider the long-term implications this step can have.

How do I avoid 20% tax on my 401k withdrawal?

The best way to avoid a 20% tax on your 401(k) withdrawal is to transfer the funds into an IRA or another workplace plan within 60 days. You can also delay social security to reduce taxes owed.

Weighing Your Options for a Secure Financial Future

Now that you understand the risks, advantages, and disadvantages of using your 401(k) to buy a house, it is important to recognize that withdrawing money from your 401(k) may not be the best choice. This decision could hinder your years of interest-free growth and have a long-term impact on your retirement savings.

If you cannot wait to become a homeowner, the best strategy is to get in touch with a financial planner and exploring other financing options.