How to Use Your 401K as a Down Payment

The general rule is that money in 401K plans stay there until the holder retires, but the IRS allows “hardship withdrawals.” One acceptable hardship is making a down payment in connection with the purchase of your primary residence.

A withdrawal is very costly, however. The cost is the earnings you forgo on the money withdrawn, plus taxes and penalties on the amount withdrawn, which must be paid in the year of withdrawal. The taxes and penalties are a crusher, so avoid withdrawals if at all possible.

A far better approach is to borrow against your account, assuming your employer permits this. You pay interest on the loan, but the interest goes back into your account, as an offset to the earnings you forgo. The money you receive is not taxable, so long as you pay it back.

The cost of borrowing against your 401K is only the earnings foregone. (The interest rate you pay the 401K account is irrelevant, since that goes from one pocket to another). If your fund has been earning 6%, for example, that is the cost of the loan to you. You will no longer be earning 6% on the money you take out as a loan. If you are a long way from retirement, you can ignore taxes because they are deferred until you retire.

The major risk in borrowing against your 401K is that if you lose your job, or change employers, you must pay back the loan in full within a short period, often 60 days. If you don’t, it is treated as a withdrawal and subjected to the same taxes and penalties. 401K accounts can usually be rolled over into 401K accounts at a new employer, or into an IRA, without triggering tax payments or penalties, but loans from a 401K cannot be rolled over.

Borrowing from your 401K should not prevent you from continuing to contribute the maximum amount that can be shielded from current taxes. If it does, the cost goes out of sight.

Usually you can borrow up to $50,000 or 50% of your 401(k) balance, whichever is smaller.

Advantages

You can get the loan quickly, usually within a week or so of applying to your company.

You don’t have to qualify for the loan through a credit approval process because, after all, you’re borrowing your own money.

The interest rate is quite low, usually at prime rate or slightly over prime, so you would pay about 5% – 6% today.

The interest that you do pay is actually paid back to you and your account. You generally have 5 years to pay it back and usually 10 years if you use if your it for the down payment on a house.

You avoid any 10% early withdrawal penalties and income taxes that would hit you if you took money out of the 401(k).

Disadvantages

You are slowing down the growth of your retirement fund. The money you withdrawal stops growing until you pay it back. Some plans don’t allow you to make more contributions if you have an outstanding loan, which hurts your retirement savings even more.

You repay the loan through payroll deduction, so the loan will cut down your take-home pay.

If you leave your job either voluntarily or involuntarily, you have to repay the entire outstanding balance in 60 days or face a huge tax bill. This can be very difficult to do when you are leaving your job, particularly if you are laid off. If you don’t pay it back, the remaining balance is hit with a 10% early withdrawal penalty and you have to pay federal and state income taxes on it that year. So if you had state taxes that could take another $20,000 of the amount.