Tired of writing those rent checks that seem to get you little, if anything, for your money? It’s understandable, then, that you would consider tapping into your 401(k) funds to come up with the down payment to pay for the purchase of your first home. These sentiments are no doubt exacerbated if the resources you need for that dream house are just sitting there in your 401(k) account.
Like much of anything else in the world of personal finance there are pluses and minuses to accessing your 401(k) assets to help pay for that dream house. Watch out for one of the more significant cons whenever touching money from a 401(k): the potential for an early withdrawal penalty. The bottom-line question then is this: can you use 401(k) assets to purchase a home without an early withdrawal penalty and (or) income tax?
There are two methods of getting funds out of a 401(k) for the purchase of a home: (1) Loan--no income tax or penalty; or (2) hardship withdrawal--income tax and penalty will be owed.
Key features of a 401(k) plan loan are as follows, according to the 401kHelpCenter:
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It's convenient. There is no credit check or long credit application form.
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You pay a low interest rate set by the plan, usually one or two percentage points above the prime rate.
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Most plans allow you to borrow for any reason.
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You are paying the interest to yourself, not to the bank.
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The interest is tax-sheltered. You don't have to pay taxes on the interest until retirement, when you take money out of the plan.
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Funds obtains from a loan are not subject to income tax or the 10% early withdrawal penalty (unless the loan defaults).
As noted by the same author, it is probably not wise to take out a 401(k) plan loan when:
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You are planning to leave your job within the next couple of years.
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There is a chance you will lose your job due to a company restructuring.
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You are nearing retirement.
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You can obtain the funds from other sources.
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You can't continue to make regular contributions to your plan.
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You can't pay off the loan right away if you are laid off or change jobs.
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You need the loan to meet everyday living expenses.
As noted in Home Guides:
1. 401(k) withdrawals under hardship exemptions, such as home buying, face 10 percent penalties on such withdrawals.
2. In addition, if you withdraw from your 401(k) you must pay income tax on it at tax time. All taxes on 401(k) withdrawals are due in the year the withdrawals occurred.
3. Lastly, withdrawing money from your 401(k) will cost you in terms of lost earnings on the money you withdrew from that 401(k).
The bottom-line is this, as noted by Home Guides: if you’re looking to use your 401 (k) to assist in a home purchase, do it through a loan. A 401(k) loan has certain advantages over a straight withdrawal. For one, the interest paid on a 401(k) loan goes back into the account, meaning even more money eventually ends up in it. 401(k) loan fees may apply, and if you default on it you'll owe standard penalties and taxes.
Image courtesy of Sherwood CC @ Flickr