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How To Do A 401k Withdrawal For Home Purchase

Written by Than Merrill

Few retirement vehicles have awarded account holders a greater peace of mind than 410(k)s. Employee contributions are simultaneously able to grow and shelter taxes for decades. Average returns can reach as high as 10% a year if the funds are allocated well enough by their respective custodians. It is worth noting, however, that 401(k)s aren’t simply relegated to monthly contributions. As it turns out, employees may draw from their 401(k)s without penalty if the money is used for a qualifying purchase. Those with a 401(k) can essentially use the money to make one of the biggest purchases of their life, which begs the question: Can I use my 401k to buy a house?

Qualifying employees may use their 401(k)s to buy a house. In fact, those with a 401(k) can use the funds in their retirement account to buy a second home, make home improvements, or even build a home. With that in mind, individuals have two options if they want to use their 401(k)s to buy a house: they may either withdraw the money directly or merely borrow from the account. That said, doing so isn’t without ramifications; early withdrawals may be met with some unexpected penalties. Employees with a 401(k) need to consult a qualified professional prior to withdrawing funds from a 401(k) before they are allowed.

What Is A 401(k) & How Does It Work?

401(k)s are retirement plans offered by many employers across the United States; they provide employees with a unique opportunity to grow wealth over long periods of time. In their simplest form, 401(k)s are personal accounts where employees may deposit money and grow savings earmarked for retirement. At their pinnacle, however, 401(k)s are one of the best ways for employees to both shelter taxes and generate long-term profits.

In order to fully understand 401(k)s and how they work, it’s best to start at the beginning. Consequently, these plans were put in place by the U.S. government and included in the Internal Revenue Service’s tax code regulations to encourage employees to save for retirement. In doing so, participating employers will allow qualified employees to transfer a portion of each paycheck (up to $20,500 per year for workers under the age of 50) into the retirement account each year.

The money is deducted from the employee’s gross income, which means it hasn’t been taxed yet. As a result, contributions actually detract from the employee’s taxable income and lessen the tax burden each year by the total amount placed into the account. In other words, employees will be taxed less because the IRS doesn’t count the contributions towards their total income.

To be clear, the money designated for a 401(k) isn’t simply put into a savings account where inflation could do more harm than good. Instead, the money is placed into the hands of a custodian who will invest the cash according to predetermined plans agreed upon by the employee. The money is often invested into an assortment of stock and mutual bond funds which fit the employee’s investment horizon and appetite for risk. As a result, the contributions are given the chance to grow and compound for years, if not decades.

It is worth pointing out that the IRS wants the contributions made to a 401(k) to be used for retirement. Therefore, any attempt to pull out cash before retirement will be met with a penalty. The earliest employees may withdraw funds from their 401(k)s without penalty is 55, but only if they have left or lost their job. Otherwise, employees will need to wait until they are 59 1/2 years old to tap into their 401(k) without penalty. Any attempt to take out the money earlier will result in a 10% withdrawal penalty, and the account holder will be expected to pay the income tax on the amount which was previously withheld.


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401k first time home buyer

Can I Use My 401(k) To Buy A House?

It is entirely possible to buy a house with the money in a 401(k) account; after all, the money belongs to the account holder. In fact, employees may use the money in their 401(k) accounts for just about anything they want. However, the IRS designed 401(k)s to help fund people’s retirements. Any attempt to withdraw the funds for anything other than retirement and before the qualifying age will result in a penalty. The opportunity cost for taking money out of the account too soon amounts to an immediate 10% penalty. In addition to the 10% hit, those taking the funds out will also need to pay income tax on the amount borrowed (since it wasn’t taxed at the time it was placed in the account initially).

How To Use Your 401(k) To Buy A House

In the event someone is comfortable taking the upfront hit (the penalty and the income tax) to use the money in their 401(k) account, they are given two options to do so:

  1. Obtain A 401(k) Loan

  2. Make A 401(k) Withdrawal

Obtain A 401(k) Loan

Employees may use a 401k loan for home purchase optionality. As their names suggest, 401(k) loans allow account holders to borrow from their retirement plans. That said, borrowers may take out a maximum of $50,000 to put towards a house. On the bright side, the 401(k) loan won’t harm the borrower’s debt-to-income ratio or credit quality. Therefore, the use of a 401(k) loan won’t hurt the borrower’s chances of qualifying for an impending mortgage. Perhaps even more importantly, the borrower will avoid the 10% punishment and income tax penalty associated with taking money out before retirement.

In return for the 401(k) loan, the borrower will be expected to pay about 1 – 2% in interest, in addition to the full amount borrowed. Furthermore, the borrower won’t be able to make any more contributions to the 401(k) until the loan has been paid back in full. As a result, any employee matching programs offered by the employer will be put on hold and compounding will be limited.

While it is possible to use a 401k loan for home purchases, the inability to make contributions and the immediate halting of employee matching programs can set retirement plans back years. Therefore, it’s important for employees to consult a qualified professional before considering this alternative.

Make A 401(k) Withdrawal

If account holders are less inclined to use a 401(k) loan, there’s always the option of making a withdrawal. As this option suggests, account holders can simply withdraw the necessary funds to purchase the home. While borrowers may gain access to more capital, this is typically considered the least desirable option to pursue.

The IRS will label the withdrawal as a “hardship withdrawal.” As described by the IRS, a hardship withdrawal is when account holders use the money in their 401(k) to cover an “immediate and heavy financial need.” As a “hardship withdrawal,” account holders will need to prove to their employees that the purchase of a home fits within the context of an “immediate and heavy financial need” before the withdrawal is approved. In the event the request is approved, the borrower will receive the 10% penalty and the withdrawal will be taxed as income. Again, the penalties for borrowing from a 401(k) are steep, so it’s important to consult a tax professional before making any big decision.

Should You Use Your 401(k) To Buy A House?

Most 401(k) accounts represent years of compounded gains. In fact, Vanguard’s latest analysis of more than five million plans revealed that the average plan consists of about $129,157. Regardless of who you are, there’s a lot you can do with that money, which begs the question: Can I use my 401k to buy a house?

To be clear, the answer is yes, but account holders need to ask themselves something more important: Should you use your 401(k) to buy a house? Just because you can use a 401(k) to buy a house, doesn’t mean you should; there are costly ramifications associated with buying a house via funds pulled from a 401(k).

As previously discussed, some options will subject the funds to a 10% penalty and tax the money as current income. Even worse, however, the borrower will significantly detract from their retirement savings. If for nothing else, every dollar removed from a 401(k) will not be given the opportunity to compound. The longer money can sit in a retirement account, the more the account holder will benefit from compound growth.

Let’s say, for example, an account holder withdraws $10,000 out of a $20,000 401(k). If we can assume the money left in the account will grow at an annualized rate of 7%, the account could reach as high as $54,000 over a 25-year period. However, if the account holder didn’t remove any funds, compounded gains could result in the same 401(k) being worth as much as $108,000 over the same period of time.

Borrowing from a 401(k) becomes particularly destructive when the account holder can’t make any contributions and the employer can’t match. For instance, if an account holder can’t make any contributions for years, they will miss out on a lot of compounded growth, further hurting their retirement funds.

When all is said and done, it is possible to buy a house with money taken out of a 401(k). Unfortunately, however, the financial ramifications are often too severe to justify the withdrawal.

Alternatives To Withdrawing Your 401(k) To Purchase A Home

The penalties associated with taking money out of a 401(k) are high enough to make someone consider other alternatives. Fortunately, there’s more than one way to receive the necessary capital to buy a home. Prospective homebuyers don’t have to use a 401(k) to buy a house; instead, they can turn to one of the following sources of capital:

  • IRA Account

  • FHA Loan

  • VA Loan

  • Mortgage Programs

IRA Account

Those looking for funds to buy a home should consider looking at an Individual Retirement Account (IRA) before they even think about their own 401(k). While 401(k) accounts and IRAs serve a similar purpose, the rules they are governed by are unique. In fact, IRAs have a specific provision which can be of assistance to first-time home buyers. More specifically, anyone who hasn’t owned a primary residence in at least two years can withdraw up to $10,000 from an IRA without receiving a 10% penalty. It is important to note that the money taken out of the account will still be taxed as income. Those who need more can take out as much as they want, but anything over $10,000 will receive the 10% penalty.

FHA Loan

The Federal Housing Administration (FHA) offers a government-backed loan which is designed to help first-time home buyers. Whereas traditional loans have become synonymous with strict requirements and higher down payments, FHA loans allow borrowers who have a credit score of 580 or higher to put down as little as 3.5% upfront. Those with a credit score between 500 and 579 will have to come up with a down payment of at least 10%. Either way, FHA loans make it easier for first-time homebuyers to get the money they need to purchase a house.

VA Loan

Loans offered by the U.S. Department of Veteran Affairs (VA Loans) were designed with the intention of helping active-duty service members, veterans and surviving spouses to buy a house. The U.S. Department of Veterans Affairs will guarantee part of the loan, meaning borrowers will get a competitive interest rate, and may not even have to come up with a down payment.

Mortgage Programs

In an attempt to promote homeownership, the federal government continues to offer a variety of mortgage programs which may provide the necessary capital to buy a home. The two most popular mortgage programs have already been discussed: VA Loans and FHA loans. However, a number of other mortgage programs exist that may be of more use to home buyers than traditional loans. At the very least, there are more than enough mortgage programs to prevent people from asking themselves “can I use my 401(k) to buy a house.”

How To Rollover A 401(k) In 4 Steps

While using a 401k withdrawal for home purchases is possible, it’s not always the best choice. That said, it is possible to rollover a 401(k) into another account that’s more friendly for prospective buyers. Fortunately, rolling over a 401(k) is not very difficult, if you know what needs to be done. Here are the four steps to successfully rollover a 401(k):

  1. Choose An IRA Provider

  2. Open An Account

  3. Move Your Funds

  4. Start Investing

Choose An IRA Provider

Step one is deciding where you want your money to go. If you already have an IRA and would like to roll your funds over into that account, you can skip to step 3. Otherwise, you’ll want to spend some time researching different brokerages and retirement account products. Important factors to benchmark include minimum balance requirements, investments, and customer service options. Bankrate.com offers the latest reviews of the top brokerages so that you can make some comparisons.

Again, only first-time home buyers can withdraw from their IRA accounts without penalty. Further, that is only if the funds are being used to purchase a home. If you aren’t a first-time homebuyer and want to invest in real estate, research self-directed IRA providers. You would then be able to withdraw funds to invest in real estate without penalty. Remember the important caveat that the real estate purchase cannot be for personal use.

Open An Account

Once you determine what type of account and brokerage you’d like to go with, give the brokerage a call. You’ll want to find out how to open the account and the exact instructions for moving your funds from your 401(k) to your IRA. Your brokerage might have a specific way that they want the check written, or perhaps they’ll require that your account information is printed on the check. When moving your precious savings, you’ll want to make sure to follow the instructions perfectly and avoid any hiccups.


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Move Your Funds

Next, it’s time to move your funds! This is the “rollover” part of the process, where you move your 401(k) savings out and into the account that you selected. To do so, there are two main methods: direct rollover or indirect a.k.a. 60-day rollover. You also shouldn’t forget the one-rollover-per-year rule, explained below.

  • Direct Rollover: Ask your broker for instructions to move your funds directly from your 401(k) to your IRA. You’ll then need to contact your 401(k) plan provider and receive assistance in carrying out the process. Most times, the provider will create a check that is made payable to your IRA brokerage, for the benefit of your account (FBO.) This means that no taxes will be withheld when the check is issued. Wiring the funds directly from your provider to your new brokerage is also a common option. Make a note of any administrative fees that might be charged and maximize your benefits by going for the free option, if there’s one available.

  • Indirect or 60-Day Rollover: If you prefer to deposit your funds yourself, the IRS stipulates that you must do so within 60 days. If you exceed this timeline, then you’ll be taxed on the full amount of your withdrawal. If you withdraw your 401(k) funds, then it’s in your best interest to deposit the funds into your IRA without delay.

  • One-Rollover-Per-Year: As of 2015, individuals are only permitted to rollover their funds from one account to another once per 12 months. This applies no matter how many IRA accounts you may have. However, this rule does not apply if you choose the direct rollover method. Overall, the direct rollover method is your safer bet.

Start Investing

Last but not least, it’s time to start investing. Once your IRA account is fully funded, you can then begin to make moves to put down funds on a property. As a reminder, you can only withdraw funds to buy real estate from an IRA without penalty if you’re a first-time homebuyer. If you’re not a first-time homebuyer, consider rolling over your 401(k) into a self-directed IRA. Once you do so, you’ll be allowed to invest in real estate without penalty. However, make sure that this investment will not be made for personal use. Allowable examples include rental properties or Real Estate Investment Trusts (REITs). Click here to learn more about REIT investing.

  • Direct Purchase: A direct purchase is when you pay all-cash from your IRA to purchase a property. This is the most simple, fast method.

  • Partnering: At times, the amount you have saved up in your IRA won’t be enough to make a down payment on a property. If this happens, don’t despair! You could go into the investment with a partner. Here, “partner” just refers to any source of funds outside of your IRA. This could be your own funds coming from elsewhere, or perhaps a family gift to help you buy your first home.

  • LLC/Checkbook: This is a unique process where you establish an LLC (limited liability company.) Then, the funds from your IRA are used to purchase real estate through the LLC. If this is done, the property is owned in the name of your LLC. This is also known as a Checkbook IRA because you have access to your funds through a checking account. Individuals might choose to do this for certain business or tax incentives. Click here to learn more about how to form a real estate LLC.

How to transfer 401k

401(k) Withdrawal FAQs

Tapping into a 401(k) for capital can be an intimidating process. At the very least, “can I use my 401k to buy a house” is just the first of many questions most account holders ask themselves. In fact, here’s a list of the most frequently asked questions people come up with when looking to withdrawal from their 401(k) accounts:

Can You Withdraw From a 401(k) Without Penalty?

For the most part, early 401(k) distributions are subject to income tax and a 10% penalty on the withdrawn amount. That said, there are a number of exceptions to the 10% additional tax. If, for example, an early distribution is made to cover a medical expense which exceeds a percentage of the borrower’s adjusted gross income, the account holder may not be subject to penalty. Other exceptions to the penalties include, but are not limited to:

  • Permanent disability

  • Being called into active military duty

  • Court-ordered withdrawals to pay for a former spouse or defendant

For a full list of the exceptions, please visit the IRS’s Exceptions to Tax on Early Distributions page.

How Much Can You Take Out Without Penalty?

With a few exceptions, account holders will be expected to pay an additional 10% early withdrawal tax on “early” or “premature” distributions (those which occur before the age of 59 1/2). In addition to the 10% penalty, the money taken out will be taxed as income for the year it’s withdrawn. Therefore, no money can be taken out before the age of retirement without penalty, unless the reason correlates to the exceptions above.

How Much Can You Take Out Of Your IRA To Buy A Home?

Account holders can take out as much money from their IRA as they want to fund a home purchase. However, to discourage “premature” withdrawals, the IRS will tax any money that’s taken out as income in the year it is withdrawn. There is, however, a provision for first-time home buyers. Anyone looking to buy a home who hasn’t owned in the last two years may take out up to $10,000 without incurring the 10% penalty which usually accompanies “early” withdrawals.

Can I Withdraw Money From My 401K To Buy A Second House?

Yes, account holders may borrow money from their 401(k) accounts to buy a second house. However, if they buy a second home with the capital retrieved from their 401(k) before the age of 59 1/2 (or they meet other exceptions), the money will be taxed as income and they will incur the 10% penalty.

Summary

With the average 401(k) holding upwards of six figures, many people are asking themselves one question: Can I use my 401k to buy a house? Many may be surprised to hear that the answer is actually yes. It is entirely possible to use a 401k to buy a house. That said, there are significant financial ramifications associated with taking money out of a 401(k) before the age of 59 1/2. While the upfront penalties may look small, preventing a retirement from compounding (even slightly) can set any aspirations of retirement back years. More often than not, it isn’t worth disrupting the growth of a 401(k) to buy a house. Instead, prospective buyers may want to consider rolling over their account or trying another alternative.


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