Borrowing From Your 401(k) to Purchase a Home: Everything You Need to Know
Buying a house can be an exciting part of your life, but it can also be one of the most stressful. From closing costs to realtor fees and down payments, buying a house could come with many hidden fees that make it more expensive than you originally thought. What’s more, coming up with the funds to cover the costs of buying a home could make it difficult to purchase the home of your dreams. Fortunately, there are a number of places you can borrow money from to purchase a home, including your 401(k).
A 401(k) account is a profit-sharing plan that allows you as an employee to contribute a portion of your paycheck to a retirement fund. The money deposited into a 401(k) is deposited tax-free, and in some cases, your employer will match your contribution.
Learn more about how you can tap into the funds in your 401(k) account to purchase a home.
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Can You Use Your 401(k) to Purchase a Home?
Yes, you can use your 401(k) to fund the purchase of a home. However, you’re not encouraged to do so, as there are a few caveats that come with borrowing or removing funds from this type of account.
If you’re purchasing a home and want to use money from your 401(k) for the down payment or closing costs, you have two options: a 401(k) loan or withdrawal. Below, you’ll find extensive details for each, including information on taxes, early withdrawal penalties, the amount you can borrow, and how to pay each back.
Taking out a loan from your 401(k) requires that you repay the loan with interest, but you’re ultimately paying yourself back. It should be noted that not every type of 401(k) plan allows for loans to be taken out, so be sure to check with your employer and your provider about their loan policy.
The IRS limits the amount on the loan you can take out of your 401(k) to 50% of the balance, or $50,000 maximum. Additionally, the IRS requires that the loan be repaid within five years of borrowing. In some cases, your employer may allow you 15 years to repay the loan borrowed from your 401(k) if you use it to buy a home.
Note that taking a loan from your 401(k) retirement plan could impact your ability to acquire a mortgage, as it weighs on your debt-to-income ratio. To qualify for a mortgage, this ratio, which is how much of your income goes toward repaying debt each month, should be 43% or less.
Additionally, you’ll incur a 10% penalty fee, which is the IRS standard fee for removing funds from your 401(k) prior to age 59½. Income tax is also charged on the amount you take a loan out for, which may make the loan more costly than other traditional options.
You can also withdraw funds from your retirement account to use on the purchase of a home. The IRS refers to this as a “hardship distribution” and allows you to make a hardship withdrawal, wherein you receive funds from your 401(k) for immediate and heavy financial need. Since the costs are directly related to the purchase of a principal residence (excluding mortgage payments), the IRS allows you to withdraw the funds from your account.
The same taxes and penalty fees apply when withdrawing funds from your retirement account. If you need more than the $50,000 maximum loan amount, there’s no limit for withdrawals. This might be the best option for you, but it’s important to note that you won’t owe the money back to your account. This means that if you don’t replenish it, your retirement account no longer has a balance.
Drawbacks to Using Your 401(k) to Purchase a Home
Using your 401(k) to purchase a home can be problematic. There are a few drawbacks that may occur when borrowing from your 401(k) plan to buy a house, including:
- Your retirement account is depleted.
- Your retirement account is no longer able to grow.
- The interest you owe is based on after-tax dollars, making it non-tax-deductible.
- You’re taking a risk and betting that you won’t lose your job. If you do, you have 60 days to repay the balance in full.
Alternative Ways to Pay for a Home Without Using Your 401(k)
Since using your 401(k) to purchase a home is often frowned upon, it’s a good idea to be aware of the alternative methods you can use to pay for a home. Fortunately, there are plenty of other ways you can pay for a home without tapping into your retirement account, including:
- Home equity loan.
- Personal loans.
- Credit cards. If you can obtain a credit card that’s offering 0% financing for a period of time, this could be a good alternative.
- Refinance your mortgage. This allows you to have cash on hand at closing and can prolong the amount and time of your mortgage.
If you’re ready to buy a house, consider all of the pros and cons of borrowing money or withdrawing funds from your retirement account before you commit. In some situations, borrowing from your 401(k) to buy a house may be the best option for you — just be sure to carefully consider the risks before doing so.
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