Can You Use Your 401(k) Funds for Purchasing a Second Home Without Tax Penalties?

A 401(k) is a qualified retirement plan that offers tax benefits to employees, including self-employed individuals. The account is designed to discourage withdrawals before age 59 ½ by restricting access to the funds and by assessing a 10-percent early withdrawal penalty. This makes a 401(k) withdrawal for a second home purchase problematic. However, most 401(k) plans allow you to borrow vested money tax- and penalty-free, as long as you pay it back on time. Your vested account balance comprises the funds you are entitled to immediately if you were to leave your job. It consists of your contributions and earnings. Employer contributions can be vested for a period of up to one year.

TL;DR (Too Long; Didn't Read)

You can borrow money tax- and penalty-free from your 401(k) to purchase a second home or for any other purpose. The same is true for withdrawals of contributions from a Roth 401(k).

401(k) Account Loans

If permitted by the plan sponsor, you can borrow up to $50,000 or one-half of your vested 401(k) account balance, whichever is less. However, you can borrow up to $10,000 even if that is more than half of your vested account balance. You must repay the loan within five years, or else it will be considered a withdrawal, triggering taxes and perhaps a 10-percent penalty. If you were to use the loan to purchase or build a first home, you’d have a longer repayment period, but this benefit doesn’t apply to second homes.

You are required to pay interest on the loan at a rate commensurate with the going interest rate in your area for a similar loan from a commercial lender to a borrower with your credit rating. Typically, this turns out to be equal to the prime rate plus one or two percentage points if you have a decent credit rating. Your 401(k) administrator can provide the details on interest charges plus any other fees.

If you leave your company and have an outstanding 401(k) loan balance, you must repay the loan right away, or it will be treated as a withdrawal, subject to taxes and penalties on the unpaid balance. Some plans grant a 60- or 90-day grace period to repay the loan after you separate from the company.

Using 401(k) loan proceeds offers these benefits when used instead of a cash withdrawal from a traditional 401(k) account:

  1. The loan is tax- and penalty-free.
  2. The loan interest is deposited back into your 401(k) account.
  3. You can usually access a 401(k) loan much easier than a withdrawal.
  4. You do not permanently reduce your retirement nest-egg.
  5. You do not permanently forego tax-deferred earnings on the loan amount.   

Distributions From a 401(k)

Normally, you cannot withdraw money from your 401(k) unless one of these events occur:

  • You reach age 59 ½.
  • You die or become totally disabled.
  • You become eligible for a qualified reservist distribution.
  • You leave your job.
  • The plan terminates and is not replaced by another qualified employer plan.
  • You suffer financial hardship.

The first three items do not trigger the 10-percent early withdrawal penalty. Your 401(k) might offer additional justifications for withdrawals. For example, it might allow you to roll over money to an IRA at your discretion. There is a tax penalty for a 401(k) withdrawal for home purchase, whether it is a first or second home.

The Early Withdrawal Penalty

The 10-percent early withdrawal penalty is waived if your withdrawal satisfies any of the following:

  • You have reached age 59 ½.
  • You die or become totally disabled.
  • You undergo financial hardship.
  • You roll it over to another qualified retirement plan or IRA.
  • You are 55 or older when you separate from the company.
  • You have medical bills exceeding 7.5 percent of your adjusted gross income.
  • You receive substantially equal regular payments based on your life expectancy.
  • You are subject to a qualified domestic relations order, such as a court order pertaining to divorce, separation or child support.
  • You are subject to an IRS levy.

Notice that home purchase does not provide a penalty exception.

Distributions from a Roth 401(k)

Some 401(k) plans provide for a separate Roth account in addition to the traditional one. A Roth 401(k) account accepts after-tax employee contributions that do not provide a tax deduction. Distributions from a Roth 401(k) are tax-free if you follow the rules:

  • Withdrawals of earnings from a Roth 401(k) are always tax- and penalty-free.
  • Distributions of Roth 401(k) earnings within five years of the account’s first contribution are taxed and penalized.
  • Distributions of Roth 401(k) earnings before age 59 ½ might be taxed and penalized unless they qualify for an exception.

If you have a Roth 401(k) account, you can use distributed contributions for any purpose, including buying or building a second home.

Distributions for Financial Hardships

Your 401(k) might allow distributions due to financial hardship. To qualify, you must show:

  • The hardship arises from a heavy and immediate financial need.
  • The distributed amount is not greater than the financial need.
  • You have first used all other sources of funds.    

Financial hardship distributions do not incur the 10-percent early withdrawal penalty. They prohibit you from contributing to the 401(k) for six months. Several circumstances automatically qualify as financial hardships, including buying or building a primary residence, but not a second home. The 401(k) rules don’t specify that you must be a first-time home buyer, unlike IRAs in which the early withdrawal rules apply to first-time homebuyers. The IRS requires that before you are allowed a hardship distribution, you must first take out a 401(k) loan, if available.

Second Home Rental

If you are self-employed and have a Solo 401(k), you can use the 401(k) to buy a house, specifically a second home that is used exclusively as a rental property. The Solo 401(k), also known as a one-participant 401(k), must be self-directed with a trustee that allows real estate transactions. The 401(k) purchases the property, pays all the expenses and receives the rental income tax-free. For this to work, you and your family cannot live in the second home or perform any activities to manage or maintain it; that job must be farmed out to a property manager who can be the trustee. The mortgage on the second home is owned by the 401(k), and the property collateralizes the loan. As the account holder, you cannot be personally liable for the mortgage.

This is a complex transaction with many tradeoffs. For example, you can’t deduct mortgage interest, depreciation and other expenses, but on the other hand, you don’t pay taxes on the rental income. In the future, you can distribute the property from the 401(k) and then use it as you like. If you set up the Solo 401(k) as a Roth account, you can distribute the home tax-free. Professional advice for this kind of transaction is invaluable.

the nest