Using Your 401(k) As A Down Payment

You've finally found the home of your dreams and secured your mortgage loan -- now comes the time to consider how you'll finance your down payment.

One popular method opted for by many home buyers today is to source funding from their employer-sponsored 401(k) program. While withdrawing from your 401(k) is usually reserved for retirement, you can make an exception w hen it comes to purchasing a new house.

Mortgage borrowers are traditionally offered two simple, cost-effective choices:

• Borrow against your 401(k). At any age, you can withdraw up to 50% of your 401(k) balance (as much as $50,000), without being taxed. The interest you pay on the loan goes back into your account -- the money you withdraw for the down payment is also not taxed if your home loan is paid off with five to 30 years.

• "Hardship" withdrawals. Many company 401(k) plans permit certain these withdrawals in certain exceptions, like the purchase of an employee's principal residence.

Accessing your 401(k) gives you immediate, assured and liquid funding for your down payment, putting you on the path to paying off your home loan sooner. Borrowers should take special consideration if tapping into their account is the right decision. With hardship withdrawals, you're subjected to taxes and penalty fees. If you leave your place of employment, most 401(k) withdrawals are due, in full, in a short period of time -- sometimes by 60 days.

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401(k) Loans

Of the two, borrowing from your 401(k) is the more desirable option. When you take out a 401(k) loan, you do not incur the early withdrawal penalty, nor do you have to pay income tax on the amount you withdraw.

But you do have to pay yourself back—that is, you have to put the money back into the account. You have to pay yourself interest, too: typically, the prime rate plus one or two percentage points. The interest rate and the other repayment terms are usually designated by your 401(k) plan provider or administrator. Generally, the maximum loan term is five years. However, if you take a loan to buy a principal residence, you may be able to pay it back over a longer period than five years.

Bear in mind that although they're being invested in your account, these repayments don't count as contributions. So, no tax break for you—no reduction of your taxable income—on these sums. And of course, no employer match for these repayments, either. Your plan provider may not even let you make contributions to the 401(k) at all while you're repaying the loan.

How much can you borrow from your 401(k)? Generally, either a sum equal to half your vested account balance or $50,000—whichever is less.

401(k) Withdrawals

Not all plan providers allow 401(k) loans. If they don't—or if you need more than the $50,000 max you're allowed to borrow—then you have to go with an outright withdrawal from the account.

Technically, you're making what's called a hardship withdrawal. Whether buying a new home counts as a hardship can be a tricky question. But generally, the IRS allows it if the money is urgently needed for, say, the down payment on a principal residence.

You are likely to incur a 10% penalty on the amount you withdraw unless you meet very stringent rules for an exemption. Even then, you will still owe income taxes on the amount of the withdrawal.4

You're only limited to the amount necessary to satisfy your financial need, and the withdrawn money does not have to be repaid. You can, of course, start replenishing the 401(k) coffers with new contributions deducted from your paycheck.

Drawbacks to Using Your 401(k) to Buy a House

Even if it's doable, tapping your retirement account for a house is problematic, no matter how you proceed. You diminish your retirement savings—not only in terms of the immediate drop in the balance but in its future potential for growth.

For example, if you have $20,000 in your account and take out $10,000 for a home, that remaining $10,000 could potentially grow to $54,000 in 25 years with a 7% annualized return. But if you leave $20,000 in your 401(k) instead of using it for a home purchase, that $20,000 could grow to $108,000 in 25 years, earning the same 7% return.

Alternatives to Tapping Your 401(k)

If you must tap into retirement savings, it's better to look at your other accounts first—specifically IRAs—especially if you're buying a first home (or your first home in a while).

Unlike 401(k)s, IRAs have special provisions for first-time homebuyers—people who haven't owned a primary residence in the last two years, according to the IRS.

First, look to take a distribution from your IRA—if you have one. You may be able to withdraw IRA contributions without penalty due to a qualified financial hardship. You can also withdraw up to $10,000 of earnings tax-free if the money is used for a first-time home purchase. As a first-time homebuyer, you can take a $10,000 distribution without owing the 10% tax penalty, although that $10,000 would be added to your federal and state income taxes. If you take a distribution larger than $10,000, a 10% penalty would be applied to the additional distribution amount. It also would be added to your income taxes.