Buying a home is a big investment that often requires years of preparation and saving. That’s because the purchase is the most costly one the average person buys, requiring both taking on  significant debt and making a substantial down payment.

The cost of a home has reached an all-time high, according to Federal Reserve data, which means that more and more would-be first-time homebuyers are finding themselves wondering just how to afford this large and long-term expense. Opting to borrow from your 401(k) retirement savings plan can be one option—but is it the right one?

Can a 401(k) be used for a home purchase? 

The simple answer is that yes, the money in an employer-sponsored tax-deferred 401(k) account can be used to buy a house or home. 

The standard 401(k) withdrawal period begins once a plan participant turns 65, or earlier if the plan allows. However, if they need to withdraw funds from this retirement account before reaching that age, a 401(k) loan or an early withdrawal may be an option. 

These withdrawn funds can then be used toward the down payment or purchase of a primary residence.

Using a 401(k) loan to buy a house

A  401(k) loan to buy a house is permitted by the IRS, provided it is permitted by the plan.  

Such a loan allows an employee to withdraw the lesser of:

• 50% of their 401(k) account’s vested balance or a minimum of $10,000, whichever is greater
• $50,000

So, if an employee has $120,000 vested in a 401(k) plan, they would only be able to take a loan of up to $50,000 from the account. However, if their vested account balance was just $15,000, they could take out a loan of up to $10,000. 

A 401(k) plan loan often needs to be repaid, allowing the employee to stay on track toward their retirement savings goals. While most 401(k) loans must be repaid over five years, loans taken to purchase a primary residence can be repaid over a longer period of time.

When a 401(k) loan is repaid, it avoids classification as a distribution. This means that a loan isn’t subject to early withdrawal penalties or income taxes on the funds. However, if the loan is not repaid according to the plan rules, it may be considered a distribution and would then be subject to both taxes and any applicable penalties.

Loans from 401(k) plans are to be repaid with interest. This means that the loan will cost the employee extra money out of pocket, but that interest is also added to their own retirement plan (since they are essentially borrowing the money from themselves).

Pros and cons of using a 401(k) to buy a house

There are certain advantages and disadvantages to using 401(k) retirement savings to purchase a home. 

‍Pros

• It’s a source of funding that doesn’t require approval of a lender.
• Penalty fees and/or income taxes may not apply if the loan is repaid on time.
• Interest on a 401(k) loan is paid into the employee’s own account.

Cons

• The loan could be subject to interest, penalties, income taxes, or a combination of the three if the account holder doesn’t follow the rules associated with taking the loan.
• Money that isn’t invested in the 401(k) plan will miss out on market gains and compounding returns, potentially causing a setback to retirement savings.
• If the borrower changes jobs, the loan must be fully repaid right away.

Alternatives to tapping your 401(k)

Saving for a down payment is the simplest way to avoid tapping into 401(k) savings to buy a home. For most future homebuyers, this means a dedicated savings strategy, though this could still take many years to achieve. 

Another option is to look for home loans that require a low (or no) down payment. There are three primary programs:

• VA loans

  allow eligible service members and their families to buy a home with no down payment.

• U.S. Department of Agriculture loans

  offer no-down-payment loans to qualified buyers who plan to buy a home in an eligible, rural area. 

• FHA-backed loans

  make it possible for some buyers to purchase a home with as little as 3.5% down, as long as they meet certain credit score requirements.

Rather than pull savings from a 401(k), first-time homebuyers can look into down payment programs in their state. Many of these programs offer down payment assistance and other incentives to eligible buyers when purchasing their first home.

Understanding 401(k) withdrawal rules

There may be other times when a saver needs to take money from a 401(k) plan before retirement. While the IRS does allow for early withdrawals from a 401(k) retirement savings account, there are some specific rules that must be followed to avoid penalties and taxes. 

Hardship withdrawals 

Withdrawing money from a 401(k) before reaching the plan withdrawal age can result in a 10% penalty, in addition to any income taxes due on the funds. However, if there is an eligible financial hardship, these funds may be able to be pulled out without an early withdrawal penalty.

A hardship distribution is when the IRS lets the saver pull money from a tax-advantaged retirement account in response to a particular event or immediate financial need. This could include non-covered medical bills, in response to an IRS levy, or for a military reservist called to active duty.

These withdrawals are only allowed when an “immediate and heavy” financial need exists. They are also limited to the actual amount necessary to satisfy that need.

Financial need is automatically considered present under a so-called safe harbor in the IRS regulations, as long as one of six situations exists. These are:

• non-covered medical expenses
• post-secondary tuition and educational expenses
• funeral expenses
• payments necessary to prevent foreclosure on a primary residence
• necessary repairs on a primary residence
• costs involved with buying a primary residence (mortgage payments excluded)

Under this safe harbor, eligible employees may be able to pull funds from a 401(k) for buying a home. However, it’s important to note that hardship distributions cannot be repaid back into the retirement account, so taking a withdrawal can potentially deal a setback to retirement planning and savings efforts.

The bottom line

Buying a home can be a huge financial undertaking, often requiring years of planning and saving. Potential homebuyers may look for ways to cover their down payment or purchase a property outright, leading them to consider one of their other big savings accounts as a source: a 401(k) retirement account.

While using a 401(k) plan to buy a home is possible—through either a loan or a hardship withdrawal—there are important and potentially costly consequences from dipping into a retirement account plan.