Should you use the money in your 401k or IRA for a down payment?

Many home buyers in Connecticut opt to use funds from their 401k or IRA accounts to make the down payment on their new house. Ordinarily, you can't take money from your 401k plan unless you retire, leave the company or become disabled, but many plans permit withdrawals when the money will be used to purchase a principal residence (occasionally only for first time buyers).   Many plans also allow taking a loan against your account, although this option only works for 401k accounts since no loans are allowed on IRA accounts.

A "pro" to either approach (withdrawal or 401k loan) is having a down payment for your new home.  This might make it possible to get a loan, or might make it less expensive by reducing the cost of mortgage insurance or other cost.  The ability to buy today may outweigh the loss you will see to your retirement funds, let's say you are able to buy a neighbor or friends home for well under market value. 

So what are the con's?

A withdrawal from your 401k or retirement account will likely create a taxable event.  One which could be very costly.  You may owe income taxes on your withdrawal as well as a penalty for early withdrawal.  This could easily be 30% or more of your withdrawal, and we can recommend a tax professional who provide information on your potential tax liability.

Another approach may be to borrow against your 401k – most employers allow for you to borrow up to 50 percent of your account balance. You pay interest on the loan, but the interest goes back into your account (you are paying yourself interest). The money you receive is not taxable as long it is paid back and plans can give you anywhere from five to 30 years to pay back your loan.  Talk with your plan admistrator, or HR department to find out about what loan options you have on your account.  Remember in calculating what you could borrow to subtract any outstanding loans, and remember your plan may limit the number of outstanding loans.  You should also calculate the cost of this loan in what you can afford to pay in month to make sure you do not over extend yourself.

There are risks involved in borrowing from your 401k. If you lose your job or leave your employer, you must pay back the loan in full within a short period, sometimes as little as 60 days. If the money is not paid back in that time, it is considered a withdrawal from your plan and subjected to the same taxes and penalties. And while 401k accounts can usually be rolled over into a new employer’s 401k without penalties, loans from a 401k cannot be rolled over.  In addition, because the funds withdrawn from your account are no longer earning compound interest, your account may be smaller when you retire. And you’ll be replacing pre-tax money with after-tax money.

In the end you must make the decision if using retirement funds is right for you.  We can help you to evaluate your situation and can refer you to other professionals (tax or legal professionals) should you need their help in making a decision.

You may want to check out our mortgage qualifier calculator or check out using gifts as down payments.