How can I use my 401(k) for a down payment?

For many prospective homeowners, the down payment is the largest barrier to buying a house. If you’re having a bit of trouble gathering funds for a down payment, you might consider using your 401(k) retirement fund as a convenient source of cash.

While it’s completely normal to consider using your 401(k) for a down payment, there are definite downsides to doing this.

What is a 401(k) and how does it work?

Your 401(k) is an earmarked investing account created primarily for retirement savings. You can defer some of your salary in this account and delay taking the money until retirement. 401(k) holders can claim a tax deduction and will see these contributions to the account grow tax-free over time. It’s generally not taxed until you take it out in retirement, but the trade-off is that access to the account is strictly limited.

In addition to the potential growth of a 401(k) over time, they come with other perks, including:

• Federal protections that help ensure adequate plan funding
• Employer matching, meaning your employer may match your contribution to your retirement fund
• High contribution limits, meaning you can put a lot of money into your account

Early withdrawal rules

Generally, withdrawals from a 401(k) cannot be made before the account holder turns 59½ years old or before they turn 55 and have left or lost their job.

Early withdrawals incur a 10% early withdrawal penalty on the amount withdrawn from the account. This amount also becomes subject to income tax immediately, as it’s no longer in a protected retirement savings account.

It’s not illegal to withdraw money from your 401(k) early, and those funds can be put toward a down payment on a house.

How to use a 401(k) to buy a house

If you do decide to withdraw from your 401(k) to buy a home, there are two options available: borrow or make a withdrawal.

Borrow with a 401(k) loan

A 401(k) loan allows you to borrow from your 401(k) account balance. Your plan administrator can explain the details, such as how much you can borrow and what the interest rate will be. In most cases, it’s one or two points higher than the prime rate.

In most cases, you’ll have five years to repay the loan. If you leave your job before repaying the full balance, however, you’ll have a much shorter time to repay your loan.

Borrowing from your 401(k) is better than making a withdrawal if you’re under 59 ½ because you can avoid the 10% early withdrawal 401(k) penalty, but the amount you withdraw will not be subject to income tax. However, if you fail to repay the loan as agreed and you’re under age 59 ½, you’ll pay taxes and a 10% penalty.

A 401(k) loan doesn’t count toward your debt-to-income ratio (DTI), and credit bureaus won’t count it. Therefore, taking a 401(k) loan won’t hurt your credit score and won’t affect your odds of qualifying for a mortgage.

Even if you decide to borrow or withdraw from your 401(k) for your down payment, you will still need to qualify for a mortgage for the outstanding purchase price of the home you buy.

What to know before taking a 401(k) loan

Here are the most important considerations if you’re considering using 401(k) to buy a house:

• Maximum amount: The maximum amount you can withdraw from a 401(k) loan varies by employer plan, but it’s usually $50,000 or less.
• Interest rate: Loans must be repaid with interest, typically ranging from 1% – 2%.
• Future contributions: Some plans may prevent you from contributing further to your 401(k) until the loan is repaid, which also pauses employer matching contributions.
• Account freezes: Taking a 401(k) loan essentially freezes your account until it’s fully repaid, potentially causing you to miss out on years of investment growth.
• Employer offering: Not all employers offer 401(k) loans.
• Loan repayment: You are required to repay the loan even if you leave your job or are laid off.
• Leaving your job: Leaving your job shortens the repayment period, and the loan must be repaid in full by the next tax filing date.
• Loan repayment: If the loan isn’t repaid on time, it is treated as a 401(k) withdrawal by the IRS, resulting in income taxes and a 10% early withdrawal penalty.
• Career/income stability: Before taking out a 401(k) loan, ensure your career and income stability to avoid financial risk. You can learn more about how lenders view retirement income, particularly with a 401k withdrawal for home purchase, here.

Make a 401(k) withdrawal

Your second option would be to make a direct 401(k) withdrawal for your home purchase. Depending on what’s in your plan, an early withdrawal could be classified as a hardship withdrawal. A hardship withdrawal involves withdrawing money by using your 401(k) to pay off a mortgage due to an immediate need.

The money you withdraw from your 401(k) is permanently removed, resulting in a loss of both principal and future compound growth in retirement savings. Withdrawn amounts are subject to regular income tax, potentially resulting in a significant tax obligation for the account holder.

What to know before making a 401(k) withdrawal

The key considerations before making a 401(k) withdrawal include the following:

• Definition: The IRS defines a 401(k) hardship withdrawal as an emergency removal of funds to cover “an immediate and heavy financial need.”
• Hardship withdrawal definition: Whether using your 401(k) for a home purchase qualifies as a hardship withdrawal is determined by your employer.
• Evidence of hardship: You must provide evidence of hardship before a hardship withdrawal can be approved.
• Early withdrawal penalty: Hardship withdrawals typically incur a 10% early withdrawal penalty.
• Exemptions exist: Exemptions exist for specific circumstances, including expenses for buying a primary residence.
• Other assets: If you have other assets available for the home purchase, you likely won’t qualify for an exemption.
• Income tax: Even if an exemption applies, the withdrawal is still subject to income tax.

Should I use my 401(k) to buy a house?

There are good reasons not to use your 401(k) to buy a house. Even if you’re comfortable with the 10% early withdrawal penalty, you will still incur long-term consequences by reducing your savings.

For example, say you take out $10,000 from a $20,000 401(k) account. You’ll have only $10,000 that will continue accruing interest. With a 7% annualized rate of return, that $10,000 could become $54,000 over 25 years, compared to $108,000 had you not withdrawn the $10,000.

Withdrawing from your 401(k) account is essentially taking out a loan against yourself. If you want to pay it back, you also need to pay interest, and the time spent paying it back is time that could have been spent growing the money in the account. You may want to weigh the pros and cons of making a withdrawal from your 401(k) before deciding if you should buy a house.

Alternatives to using your 401(k) to buy a house

Let’s walk through a few other options that you could use instead of borrowing or withdrawing from your 401(k) to buy your house.

IRA account

IRAs are designed with special provisions and exceptions to early distributions for first-time home buyers, which the IRS defines as anyone who hasn’t owned a primary residence within the previous two years. First-time home buyers are allowed to withdraw up to $10,000 without incurring the 10% penalty. However, that $10,000 is still subject to state and federal income taxes. If your IRA withdrawal for a home purchase exceeds $10,000, then the 10% penalty is applied to the additional distribution.

A Roth IRA may be an even better option if you have one. Some plans allow you to make a hardship withdrawal, and up to $10,000 can be withdrawn for the express purpose of buying your first home.

FHA loan

A Federal Housing Administration (FHA) loan is a government-backed mortgage that can make it easier for first-time home buyers to achieve homeownership.

FHA lenders have looser borrower qualifications compared to other loan options, including low down payment options and more flexible credit score requirements. FHA loans require a minimum down payment of 3.5%, but only if your credit score is 580 or higher. If your score is between 500 – 579, then the minimum down payment is 10%. With Rocket Mortgage^®, the minimum credit score requirement for an FHA loan is 580².

Consider the following requirements when applying for an FHA loan:

• FHA loans require the borrower to have mortgage insurance for the life of the loan, or for 11 years if you made at least a 10% down payment.
• FHA loan mortgage insurance includes a 1.75% up-front premium charge and an annual premium, anywhere from 0.45% – 1.05%, based on four factors:
• Mortgage term
• Loan-to-value ratio (LTV) – how much of the value of the home you can borrow with a mortgage
• Total mortgage amount
• Size of your down payment

VA Loan

If you’re an eligible service member, veteran, or surviving spouse, a Department of Veterans Affairs (VA) loan could be a better alternative to withdrawing from your 401(k) account. A VA loan is government backed and offers a lower interest rate and more flexible terms. The one significant difference is that a VA loan requires no down payment. To qualify for a VA loan, you must satisfy at least one of these criteria:

• Served more than 6 years with the National Guard or reserves, or at least 90 days under Title 32, with 30 of those days being consecutive
• Served 90 consecutive days of active service during wartime
• Served 181 days of active service during peacetime
• Are the spouse of a service member who lost their life, either in the line of duty or as the result of an injury gained during their active service
• Veterans discharged by reason of disability have their service time requirements waived. If you meet one of these requirements, you can obtain a Certificate of Eligibility (COE) for a VA loan by demonstrating proof of service as a veteran, active member, or spouse.

FAQ

Consider these questions and answers when determining if you should use your 401(k) funds to buy a home.

How much of my 401(k) can I use to buy a house?

Depending on how much is invested in your plan, you could take out up to $50,000 from a 401k for a down payment on a house. However, it’s important to check with your plan administrator to understand the conditions that must be met and the total amount you can take out.

When can I withdraw funds from a 401(k) account without a penalty?

You can withdraw funds from your 401(k) and avoid the early withdrawal penalty when you turn 59½ years old. You can also tap into your 401(k) before you turn 55 if you left or lost your job. However, even if you’re 59 ½, you’ll want to ensure you leave enough money in your account to cover your retirement costs.

Can I use my 401(k) to buy a second home?

You can use the money from your 401(k) to purchase a second home. However, you’ll have to pay taxes on the amount you took out of your 401(k). If applicable, you might also be subject to the early withdrawal fee.

The bottom line on using a 401(k) to buy a house

It may be tempting to view your 401(k) account as an untapped source of cash, especially if you’re trying to come up with the money for a down payment on your new home.

While this can be a viable option and there are ways to mitigate the penalties, it should be used only as a last resort. Whatever you decide, carefully consider the consequences of any financial decision and consult with a mortgage specialist and a financial advisor before committing to an option.

If you want to learn more about what you may qualify for, you can reach out to Rocket Mortgage^® today.

This article is for informational purposes only and is not intended to provide financial, investment, or tax advice. You should consult a qualified financial or tax professional before making decisions regarding your retirement funds or mortgage.

To qualify for this offer, you must meet all standard FHA eligibility requirements. In addition, your total mortgage payment, including taxes and insurance, cannot exceed 38% of your income, your debt-to-income (DTI) ratio cannot exceed 45%, and you must have 12 months of verifiable housing history immediately prior to your application, no late payments 30 days or greater in the last 12-months, and no derogatory marks on your credit report. Not available on jumbo loans. Asset statements may be needed, no more than 1 day of non-sufficient fund fees are allowed in the most recent 2 months prior to application. Additional restrictions/conditions may apply.

Rocket Mortgage is a VA-approved lender, not endorsed or sponsored by the Dept. of Veterans Affairs or any government agency.