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 $450,000, potential buyers often need $45,000 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

Retirement Account Early Withdrawal Penalties

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.

• Traditional 401(k): A 401(k) is an employer-sponsored retirement account. If you access funds before the age of 59.5, you generally face a 10% early withdrawal penalty. The withdrawal is also subject to regular income tax.
• Traditional IRA: Traditional IRAs are retirement accounts you open on your own. Similar to 401(k)s, tapping money from a traditional IRA before age 59.5 typically incurs a 10% early withdrawal penalty and you’ll need to pay income tax on the distribution.
• Roth IRA: You can withdraw Roth IRA contributions (but not gains) without penalty or taxes at any time. After your account’s been open for five years or you’re at least 59.5, you can withdraw any earnings without penalty as well.

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.

Can I Use My 401(k) to Buy a House?

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 where 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.

Pros of Using Your 401(k) to Buy a Home

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.

• Larger down payment: Using your retirement savings can boost your down payment, enabling you to secure a more favorable mortgage rate and potentially avoid the need for private mortgage insurance.
• Timing the market: If you believe real estate prices will continue to rise, using your retirement funds now to purchase a home might be a wise move. By getting into the market sooner, you might benefit from future appreciation on your new home.

Cons of Using Your 401(k) to Buy a House

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.”

• Penalties and fees: As we discussed, using your 401(k) to buy a house comes with a 10% early withdrawal penalty and you’ll pay income tax on the entire amount. That’s an expensive way to come up with money for a down payment.
• Jeopardizing your retirement goals: Withdrawing money from your retirement account means depleting your nest egg, which could impact your ability to retire comfortably.
• Loss of potential growth: By removing funds from your retirement account, you lose the opportunity for that money to continue growing through investment returns, potentially affecting your future financial outlook.

IRA Exemption for First-Time Home Buyers

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.

Another Option: Taking Out a 401(k) Loan

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:

• You’re basically paying yourself back with interest. It’s not like taking out a new private loan.
• A 401(k) loan doesn’t have the qualification and underwriting requirements of traditional mortgage lenders.
• You don’t pay income taxes or face a 10% tax penalty on 401(k) loans — so long as the loan is repaid on time.

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.”

Drawbacks of 401(k) Loans

These perks don’t mean 401(k) loans are a perfect solution for everyone in every situation.

Some drawbacks of 401(k) loans include:

• If you fail to repay the loan in five years, the outstanding balance may be treated as a taxable distribution, subject to income tax and penalties.
• If you leave your job before repaying the loan, you may be required to repay the outstanding balance in full when you file your taxes.
• You’ll face loan fees from the provider.
• 401(k) loans typically can’t be refinanced just because interest rates go down.
• Some plans won’t allow you to make 401(k) contributions while repaying your loan.

“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.”

When Does a 401(k) Loan Make Sense?

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:

1. Taking out a 401(k) loan will get you to a 20% down payment.
2. Your new mortgage will be the same amount or less than your rent.
3. Your job is secure.

“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.”

Alternatives to Using Your Retirement Account to Buy a House

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.

Reduce Your Expenses and Increase Your Income

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.

Consider a Federal Housing Administration Loan

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 500, and you can also make a down payment as low as 3.5%, making these loans attractive for first-time homebuyers.

See If You Qualify for Certain Loans or Help

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.