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

You can use 401(k) funds for home purchases, but may face early-withdrawal penalties as well as income tax.

You can use 401(k) funds for home purchases, but may face early-withdrawal penalties as well as income tax.

In a traditional 401(k) retirement savings account, the IRS does not levy income tax on the contributions, but taxes withdrawals; in a Roth, the contributions are taxable, while distributions are tax-free with certain conditions. There are strict rules on distributions, however. Although you can withdraw money for the purchase of a second home, there may be some tax consequences as well as early-withdrawal penalties.

Hardship Withdrawals

When employers set up 401(k) plans, the plan administrators enforce their own rules on distributions. The IRS allows these plans to permit hardship withdrawals, but the purchase of a second home does not qualify, in most cases. Under the IRS guidelines, hardship withdrawals for home purchases are limited to a principal residence, not a second or vacation home.

Roth 401(k)s

Under a Roth 401(k) plan, your administrator may permit a withdrawal at any time, for any reason (including the purchase of a second home). Contributions to a Roth are not made "pre-tax," but withdrawals are tax-free. By the IRS rules on Roths, the withdrawal is free of income tax only if the funds have been in the account for at least five years. In addition, if your funds meet that condition, there is no penalty for early withdrawals before age 59-1/2.

Exceptions on Early Withdrawal Penalties

The IRS makes some exceptions to the early-withdrawal penalty on 401(k)s. You may take the early distribution without penalty if you have reached 55 and are retiring. In addition, if you've set up substantially equal regular payments based on your life expectancy, the penalty does not apply. In addition, if the second home purchase was required by a divorce decree or marital separation agreement, then there is no early-withdrawal penalty.

Reporting Distributions

The IRS does not allow 401(k) administrators to restrict the use of money you withdraw from your account. You can use it for a second home purchase or any other reason; nor will a property seller restrict the source of funds used for a down payment or closing costs. Your plan administrator will report the distribution on Form 1099-R, and code the distribution type in Box 7 (death, disability, normal distribution, direct rollover, etc.). If that early-withdrawal exception does not appear in this box, you must complete Form 5329 to report the distribution and avoid the penalty.

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