First Time Home Buyer 401(k) Withdrawal

Congress created 401(k) qualified retirement accounts to help employees save for their golden years, and therefore placed restrictions on early withdrawals. All distributions from a traditional 401(k) are taxed as ordinary income, and the Internal Revenue Service levies an additional 10-percent penalty tax on early withdrawals, such as an early distribution from 401(k) for a home purchase, unless an exception applies. Notwithstanding the restrictions, you can use your 401(k) to help purchase a primary residence, and with some planning, you might be able to avoid the penalty tax.

Early Withdrawals From a 401(k)

Normally, you cannot take a distribution from your 401(k) unless certain circumstances apply. Furthermore, certain withdrawals trigger the 10-percent penalty. You (or your beneficiaries) can withdraw funds from your 401(k) and avoid the penalty tax if any of these circumstances apply:

  • You’ve reached age 59 1/2.
  • You separated from your job at age 55 or older.
  • You receive substantially equal payments each year from your 401(k) based on your estimated life expectancy.
  • Your employer terminates the 401(k) plan.
  • You die.
  • You become totally and permanently disabled.
  • You roll over the withdrawn amount to another qualified employee plan or a traditional IRA.
  • You have deductible medical expenses exceeding 7.5 percent of your adjusted gross income.
  • You are subject to an IRS levy.
  • You are subject to a qualified domestic relations order (that is, a court order relating to separation, divorce or child support).

As you can see, there is no penalty-tax exception for purchasing a home. You might be able to withdraw 401(k) funds for this purpose, but you will have to pay the 10-percent penalty on the amount distributed.

Early Distribution from 401(k)

The IRS gives your employer the right, but not the obligation, to approve 401(k) early withdrawals due to financial hardship. To qualify, you must demonstrate that:

  • The hardship stems from an immediate and heavy financial need.
  • The distributed amount won’t exceed the financial need.
  • You have reasonably tapped all other sources of funds.

Financial hardship distributions trigger the 10-percent early withdrawal penalty and prohibit you from making a new 401(k) contribution for six months. Several circumstances automatically qualify as financial hardships, including the purchase of a primary residence. Note that 401(k) rules don’t require it be a first-time home purchase to qualify as a financial hardship. Contrast this with IRA early-withdrawal rules which pertain specifically to first-time home purchases. The IRS normally requires that you first take out a 401(k) loan to cover financial hardships before allowing a hardship distribution, unless the loan would disqualify you from accessing other funds required to remedy the hardship.

Using 401(k) Loans

One valuable feature of a 401(k) plan is the opportunity to borrow from it. You can borrow the lesser of half your vested account balance and $50,000. Normally, you must fully repay the loan within five years, or else the unpaid balance is treated as a distribution, subject to taxes and penalty. However, loans made to purchase a primary residence are exempt from the five-year deadline, and you can take up to 15 years to repay the loan. You must pay yourself interest on the borrowed balance, typically 1-or-2 percentage points above the prime rate, although your 401(k) administrator can give you the precise interest rate. A 401(k) loan lets you avoid taxes and the 10-percent early withdrawal penalty associated with withdrawal. If a 401(k) loan does not provide all the funds you need for the down payment on your home, you can follow up with an early withdrawal. This strategy will reduce the withdrawn amount, as well as the tax and penalty you’ll have to fork over.

If you separate from your company and have an outstanding balance on a 401(k) loan, the plan sponsor might require you to repay the loan, often granting a grace period of 60-or-90 days, to avoid recharacterizing the loan as a taxable distribution. If you can tap other resources to repay the loan, you can include the former loan balance in a tax-free rollover to another qualified employee plan or IRA, thereby avoiding the taxes and penalties you would have faced if the loan balance remained unpaid.

Rollover to IRA

If you haven’t owned a home in the last two years, the IRS considers you a first-time homebuyer, even if you owned a home, say, three years ago. A 401(k) first-time home buyer might want to exercise the option of rolling funds over to an IRA without triggering taxes or penalties. This alternative can save money because first-time homebuyers can withdraw up to $10,000 from a traditional IRA to purchase a home without incurring the 10-percent early withdrawal penalty. Your spouse can also withdraw $10,000 from his IRA, giving you $20,000 you can apply to your home purchase penalty-free. Of course, you will still have to pay income tax on any traditional IRA withdrawal.

Roth IRAs have different rules. Any money you roll over from a 401(k) to a Roth IRA must be included in your current taxable income. You can then freely withdraw contributions (but not earnings) at any time tax- and penalty-free. If you own the Roth for at least five years, you can withdraw earnings up to $10,000 for a first-time home purchase without paying taxes or penalties.

You cannot borrow money from an IRA. You also cannot have your IRA purchase the home you will occupy, because this would run afoul of IRA self-dealing rules.

Implications of a 401(k) Withdrawal

Early withdrawals from a 401(k) for home purchase reduces the money you’ll have for your retirement. You lose future tax-deferred earnings on these withdrawals, and you’ll be immediately hit with taxes and penalties. You cannot replenish the withdrawn amount separately from your normal contribution limits. This increases the risk that you will outlive your retirement savings.

On the other hand, money invested in a home purchase benefits from the home’s tax-deferred appreciation until you sell it, at which point you might qualify for up to $250,000 in tax-free profits ($500,000 for married couples filing jointly). Any excess profit above this limit will be taxed at the favorable, long-term capital gains rate, assuming you owned the home for at least one year. If your ownership years coincide with strong real estate market, you might reap substantial tax benefits when you sell your home, above and beyond the tax-deductibility of mortgage interest. You also eliminate the expense of renting your abode, which might help you contribute more to your retirement accounts. If you must pay the penalty tax on an early withdrawal, you’ll have to complete and file IRS Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.

The 401(k) loan option eliminates the prospect of paying taxes and penalties on an early withdrawal to purchase a home. Since you can take up to 15 years to repay this loan and the loan interest goes back into your 401(k) account, the long-term impact of the loan might be small or even positive. Since you must first take a 401(k) loan (if available) before you can make a financial hardship withdrawal, the loan route requires serious consideration.

The IRA rollover option might also let you bypass taxes and penalties, but you must be a first-time home purchaser and you are limited to a $10,000 withdrawal.

The uniqueness and complexity of your situation necessitate careful analysis to determine which alternative is most likely to provide the best long-term results.

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