The money in a 401(k) account is meant to be left alone until you reach retirement age, a good long time from now. But there are cases when it might be tempting to withdraw some of the funds in the account. For example, some plans allow you to use money in your 401(k) as a down payment for your first home or primary residence. Not all plans allow hardship withdrawals, so check with yours before planning on using the funds.
Since the money you invest in a 401(k) is tax deferred, you will owe income tax on the amount you withdraw to use as a down payment. The additional tax could hurt you financially, because you might be pushed into a higher tax bracket. In addition to income tax, you will also need to pay a 10 percent penalty tax on the amount, since you are not 59 1/2 and the withdrawal does not meet the IRS exceptions to the penalty tax.
Save yourself the income taxes and penalty tax by borrowing money from your 401(k) instead of taking a hardship withdrawal to purchase your home. 401(k) loans have drawbacks and advantages. You are borrowing money from yourself, so you do not need to have your credit checked. You also pay yourself the interest and avoid the taxes. You have to pay the loan back within a set period of time, up to 10 years if you use it to purchase a house. If you leave your job, however, you will need to repay the loan in a lump sum.
One way to avoid the 10 percent penalty tax and the troubles of a loan is to roll over an amount from your 401(k) plan to a Roth IRA. The IRS allows you to use money in your Roth penalty-free to purchase or build your first home. When you roll over money in a 401(k) to a Roth IRA, you will need to pay income tax on the amount, as long as you did not already pay the tax on it.
Using money from a retirement plan to purchase a home is not always the best option. Even if you eventually replace the money, the amount you end up with in retirement will be less than it could have been, since you missed months or years of earning opportunity. Other options for purchasing a first home include using a program that lets you put down less money than is standard to purchase a home or waiting until you have enough money in your non-retirement savings to put a substantial amount down.
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- The Pros & Cons of 401k Withdrawals