The purchase of a home, especially your first one, can be a life-changing event. Qualified retirement plans, such as 401(k)s, provide a couple of ways to use plan money to buy your primary home. Of these, the only tax-free source of funds is a 401(k) loan. However, failure to repay the loan in a timely manner can result in taxes and interest.
TL;DR (Too Long; Didn't Read)
If you take out a loan from your 401(k) to buy your first home, it's tax-free as long as you repay it within the required time period.
Basics of Qualified Distributions
Qualified defined contribution plans like the 401(k) must follow the rules of the Employee Retirement Income Security Act, or ERISA. Those rules set out how you can siphon cash from your plan by either withdrawing or borrowing the money. A withdrawal increases your taxable income, and the Internal Revenue Service may hit you with a 10 percent early withdrawal penalty if you are under age 59 1/2. However, the rules provide certain exceptions to the penalty fee, including hardship distributions.
Borrowing from Your 401(K) to Buy a House
You can arrange a loan from your 401(k) plan for any reason. That is, you don’t have to be a 401(k) first-time home buyer to get a loan as long as your plan provides for loans – not all plans do. If loans are allowed, 401(k) home loan rules permit you to borrow up to the greater of $10,000 and half of your account balance, but no more than $50,000.
You will have to pay interest on the loan, but it is usually at a low rate such as prime. The interest you pay, minus any fees, goes back into your account balance.
Loan Repayment Considerations
Normally, you have five years to repay the loan. However, your employer may give you up to 15 years to pay back money you use to buy a home. If you leave your job, you have a short time (commonly, two to three months) to pay back the loan, or the IRS will tax you on the amount and, if you are under age 55, tack on the 10 percent penalty.
While you can repay a loan, it temporarily reduces the money available for tax-deferred growth. To some extent, the interest you pay on the loan helps compensate for the loss of earnings, but loan interest is generally not tax-deductible. Thus, you’ll pay taxes twice on loan interest – once when you earn the money to pay the interest, and again when you withdraw money from your 401(k).
Treatment of Hardship Distributions
Only after you first borrow money from your 401(k) can you qualify for a hardship distribution. You must have an immediate need for cash and not have other resources (such as a savings account or a vacation home you can sell) that you can reasonably use to meet that need. Buying your primary home is considered an immediate need that qualifies as a hardship distribution.
In previous times, you could withdraw only your plan contributions, not investment earnings, as a hardship distribution. However, beginning in 2020, your employer may choose to include earnings on elective and other contributions. The new rule allows employers to implement this change as soon as the tax year 2019.
You must include the hardship distribution in your current taxable income (although you won’t have to pay an early withdrawal penalty) and can’t use it to pay your mortgage. You must wait six months to resume contributing to your plan after receiving a hardship distribution. You can’t roll over money you receive because of a hardship distribution.
One Other Option
You might decide to suspend your contributions to your plan and instead squirrel away post-tax money for your home purchase. Of course, you’ll lose the tax deduction and tax-free growth on the money you divert. You’ll also miss any matching contributions your employer would have made.
On the other hand, you can gain from tax-deferred or tax-free appreciation of your home’s value, and mortgage interest is deductible. By using your pay directly instead of contributing it to your 401(k) and then borrowing it, you don’t risk penalties and interest if you fail to repay the loan on time.
Prudence suggests you compare the likely post-tax costs and benefits of your various options for funding the purchase of your home.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.