The Lincoln Lending Blog

Saving for a down payment on a home takes time. For some people, it may feel as if the goalpost is constantly moving as home prices appreciate, and you feel the need to save more and more to make a comfortable down payment. You may even turn to your 401(k) retirement account and wonder whether you can use that money to help you buy a home.

In fact, you can use 401(k) funds to make a down payment, but should you?

Taking money from your retirement fund may help you purchase a home sooner, but it may also negatively affect your financial prospects in retirement. Before you make any decisions, speak to your financial advisor or a home loan coach. Your retirement savings are your safety net for your golden years, so you may not be doing yourself any favors by raiding it now.

If you do decide to use your 401(k) funds to help with your down payment, two of your options are to take a hardship withdrawal or take a loan from your 401(k). In this article, we’ll explore the pros and cons of these two options.

401(k) Hardship Withdrawals

Some 401(k) plans offer the option of a hardship withdrawal. The IRS stipulates that an account holder has “immediate and heavy financial need” for which he or she needs to use the 401(k) funds. Each situation is unique, so you should consult your financial advisor or your 401(k) manager about what your retirement account allows and what’s best in your situation. 

Appropriate uses for a hardship withdrawal are often:

• Certain medical expenses
• Home buying expenses for a primary residence
• Expenses to stop foreclosure or eviction
• Expenses to a primary residence from fire, flood, earthquake, etc.
• Up to 12 months of tuition and fees, or
• Burial or funeral expenses

For most people, a 401(k) hardship withdrawal should be a last resort. If you have any other assets that you could use for your down payment, then you may not be approved for the withdrawal. In most cases, you’ll need to provide documentation to your employer to justify your hardship. Also, the amount you withdraw is not without limit; you can usually only withdraw an amount that covers the down payment, plus taxes and penalties, but no more.

Benefits of a Hardship Withdrawal

Taking a hardship withdrawal can help you purchase a home and begin to live rent-free. Rather than paying a monthly rent on a property that you do not own, you can instead make payments toward your home, which is an investment itself.

When you make a hardship withdrawal, you may not be obligated to repay the money. In some cases, you can withdraw both dollars that you contributed AND dollars that your employer contributed. Being able to withdraw employer-matched contributions doubles your down payment saving speed, which gets you into a new home much sooner than you could on your own.

Prior to 2018, you usually had to wait for six months after a withdrawal to make any new contributions to your retirement account. However, many 401(k) plans now allow you to continue making contributions immediately following a withdrawal, which means that you will not miss any employer contributions.

Downsides of a Hardship Withdrawal

When you take a withdrawal from your 401(k), you may have to pay taxes on the distribution amount. Since your withdrawal may count as income on your taxes, it may bump you into a higher tax bracket, which would increase your tax rate. You should consult your financial advisor to help you plan accordingly. You may need to withdraw a dollar amount that is large enough for your desired down payment, plus your income taxes.

Depending on the specifics of the 401(k) account, you may have to pay a 10% penalty on withdrawals if you are under age 59 ½, even for a hardship. Unlike some IRA retirement accounts, 401(k) accounts typically do not offer a first-time homebuyer exception. Taking a sizable withdrawal from your 401(k) may not be worth it once you calculate for taxes and penalties. A home loan coach or tax advisor can help you calculate different scenarios to decide whether using a hardship withdrawal is a sound financial decision.

401(k) Loan

A second option for using 401(k) savings for a down payment is taking a loan from your retirement account. In some cases, you can borrow the lesser of $50,000 or half the value of the account for a home purchase, depending upon your 401(k) account. Borrowers usually have five years to repay the loan in its entirety.

Benefits of a 401(k) Loan

The primary benefit of taking a loan from your retirement account rather than a withdrawal is that, in most cases, you will not pay taxes or penalties on the money. You DO usually have to pay interest on the loan, though. However, the interest payments typically go back into your 401(k) rather than to a bank or lender.

Downsides of a 401(k) Loan

Since you usually only have five years to repay the loan, your monthly payments may be high. For example, if you take a full $50,000 loan, your monthly payment will be $833, plus interest. You should disclose any 401(k) loans to your mortgage lender because it may affect your ability to qualify for a home loan. As your debt level increases, your ability to repay your mortgage may come into question. You may have funds to make a down payment, but no ability to qualify for a home loan.

If you only intend to make a modest down payment because you plan to seek a VA loan, USDA Rural Development loan, or an FHA loan, then a 401(k) loan may be a smart option. However, if you intend to use 401(k) funds to make a large down payment while also applying for a conventional home loan, you may have a hard time qualifying. Speak with a home loan coach or financial advisor to run the numbers and see how a 401(k) loan could affect your mortgage eligibility.

One of the most significant downsides of a 401(k) loan is that, in some cases, you may not be able to make additional contributions to your 401(k) until you’ve repaid the loan. Not only could you lose all of the appreciation that those dollars would have had if you had left them alone, but you may also be unable to add new dollars to the account.

What If You Default on the Loan?

If you default on repaying your 401(k) loan, it often turns into a withdrawal, and you may be subject to paying income taxes on the withdrawal plus a 10% penalty if you’re under age 59 ½. Plus, you can lose the appreciation that the income would have had if you hadn’t taken it out of the account.

If you lose or leave your job while you still owe money on the 401(k) loan, you may have to repay the remaining balance in full by the date that your next federal tax return is due. If you’re unable to pay the balance, it sometimes acts as a default and becomes a withdrawal with the same consequences.

Should You Draw from Your 401(k)?

You don’t always have to make a large down payment to buy a home. Learn more about low down payment loan programs like VA home loans or USDA Rural Development loans and see whether you’re eligible for a $0 down home loan.

Before you make a withdrawal or take a loan from your 401(k), meet with a home loan coach and financial advisor to see how it could affect your financial future and your ability to qualify for a home loan. The loan experts at Lincoln Lending can help you determine the best path to homeownership based on your unique circumstances. Get in touch to schedule a no-cost, no-obligation coaching session today.