If you’re looking to purchase a home, and have funds invested in a 401k plan that you’d like to use as a downpayment, here are all the different options you can take, and important factors to consider before making a final decision.

Can I use my 401k to purchase a home?

Some retirement plans, like a solo 401k or a self-directed IRA, allows you to invest in alternative assets like real estate. With these accounts, you’re able to purchase an investment property directly through your retirement plan. Unfortunately, a 401k does not allow you to invest in alternative assets like real estate.

You can use your 401k funds to purchase a home either by withdrawing money out of your account, or by taking a 401k loan if your plan allows it.

Withdrawing money out of your account to buy a home

If you’re under the age of 59½, any distributions you take from your 401k will be hit with a 10% early distribution penalty plus income taxes. For example, if you have a $500,000 in your 401k that you’d like to withdraw, an early distribution penalty would require that you pay $50,000 of it to the IRS, and also pay income taxes on your $500,000 withdrawal.

On top of the hefty penalty, a lump sum withdrawal of $500,000 would put you in one of the highest tax brackets (35%) through the distribution alone. If you earned any income, it could push you into the highest tax bracket possible (37%).

A withdrawal not only incurs the most penalties and fees, it also depletes your retirement account of funds that would otherwise be invested, with compound interest. The better option could be to take a 401k loan, if your plan provider offers the option.

Taking a 401k loan to buy a home

Some, not all, 401k plan providers allow the option to take a 401k loan. With a 401k loan, you’re allowed to borrow up to 50% of your 401k account balance, up to a maximum of $50,000. Interest rates are usually prime rate plus one or two percent, and the process for getting a loan is actually faster and simpler than if you were to get a loan from a financial institution.

401k loans aren’t actually loans; you’re just lending money to yourself from your own 401k. Therefore, there are no lenders, credit checks, or long application processes involved. Late payments do not affect your credit score, but if you fail to repay the loan on time, it could be treated as a distribution, which would incur the 10% early distribution penalty plus income taxes if you’re under the age of 59½.

How long do I have to repay the 401k loan?

Typically, a 401k loan gives you 5 years to repay the money. However, if you use the money to purchase a primary residence, you could get up to 15 years to pay it back. The actual amount of time you’ll have depends on your plan provider.

Things to look out for with a 401k loan

  • Some plan providers may not allow you to make any further contributions to your 401k if you have an outstanding 401k loan. If your employer offers 401k matching, in addition to not being able to contribute any money, you’ll also miss out on years of free employer match contributions.
  • If you’re late to repay the loan, it won’t affect your credit score but you could end up paying a large penalty plus income taxes. If you’re under the age of 59½, you’ll have to pay a 10% penalty plus income taxes.
  • If you’re terminated, or leave your position, your loan repayment deadlines can change. Usually, you’ll have to pay the loan back in full by your next tax filing deadline. If you can’t repay the loan, it’ll be treated as an early distribution by the IRS.

What about a hardship withdrawal?

The IRS technically lists the purchase of a primary residence as a hardship withdrawal. You’re allowed to withdraw up to $10,000 to purchase a primary residence, and you wouldn’t have to pay a 10% penalty.

The issue with the hardship withdrawal is that it’s completely up to the plan provider to issue the withdrawal as a hardship withdrawal. If you have any other properties that can count as a primary residence, you may get rejected.

Additionally, while you don’t have to pay the 10% penalty, you’ll still have to pay regular income taxes. If you’re in a high tax bracket when you request the withdrawal, you could end up owing a large percentage of it to the IRS in the form of income tax.

An IRA can be more lenient with home purchase withdrawals

With a 401k, the purchase of primary residence is classified as a hardship withdrawal, which the IRS defines as an immediate and heavy financial need. And because it’s up to the plan provider, it can be more difficult for your “hardship withdrawal” to be accepted.

The traditional IRA also lets you take out a withdrawal of $10,000 for a primary home purchase, and is easier to access than a 401k. A traditional IRA has a special provision that lets you withdraw $10,000 without the 10% early distribution penalty if you haven’t owned a primary residence in the last two years.

If you withdraw more than $10,000, you’ll have to pay the 10% penalty on the excessive amount over $10,000. For example, if you need to withdraw $25,000 from your traditional IRA for a home purchase, $10,000 would be able to be withdrawn with no penalties, and the remaining $15,000 would be hit with a 10% penalty of $1,500.

Keep in mind that, while you don’t have to pay the 10% penalty on withdrawals up to $10,000, you’ll still owe income taxes on your withdrawals.

Roth IRA withdrawals

If you also have a Roth IRA, you could withdraw your contributions made to your account at any age without penalties. Any earnings from your account would be hit with a 10% penalty plus income taxes if you’re under the age of 59½ and your Roth IRA is under 5 years old.

For example, if you contributed $30,000 to your Roth IRA over the years, and it grew to a balance of $100,000 through your investment earnings, you could withdraw $30,000 from your account at any age without penalties. However, you cannot withdraw the $70,000 in earnings until you’re at least 59½ years old, and your Roth IRA is at least 5 years old.

Set up a new solo 401k in under 10 minutes

Contribute up to $69,000 and invest in any asset class with tax-free compounding.

Anyone who makes money from a business, freelancing, or a side hustle is eligible, as long as you have no employees.