We totally get it. It seems like almost everyone wants to own their own home. Not only is it the American Dream, but it’s also one of the best ways to build wealth.
But getting into a home can be an uphill climb. Most aspiring home buyers have a tough time saving up a down payment—so they start getting creative. For a lot of people, their biggest pile of cash is actually in their 401(k). So why not use the money in your 401(k) to buy a house?
It’s super tempting. But here’s the deal: While homeownership is a great goal, it’s not worth mortgaging your future retirement plans (pun intended). Trust us, that “American Dream” could turn into a nightmare in the long term.
Here’s the simple answer: It’s never, ever a good idea to take money out of your 401(k) early (or any other type of retirement account) to pay for something like a house. Period. End of story.
So . . . we already told you that using your 401(k) to buy a house is a bad idea, right? And you want to learn more? Oh-kay. But don’t say we didn’t warn you.
- Taking money out of your 401(k) to buy a house is never, ever a good idea.
- There are two ways to buy a house using money from your 401(k): early/hardship withdrawal or a loan.
- Early withdrawal means taking money out of your 401(k) before you’re ready or old enough to retire.
- Hardship withdrawal is a type of early withdrawal, but you need to prove that you need your 401(k) money to solve some huge financial problem.
- Early 401(k) withdrawals are subject to costly fees and taxes, including a 20% federal tax withholding and a 10% penalty—meaning potentially 30% of your money is gone before you even spend it!
- 401(k) loans allow you to borrow money from your account and repay it over time. They avoid the penalty and taxes at first but leave you financially vulnerable and cripple you with debt.
- Any withdrawal or loan from a 401(k) robs you of one of the greatest gifts known to mankind: compound growth.
How Can I Use My 401(k) to Purchase a Home?
There are two ways to use your 401(k) to buy a house. That’s right . . . it can be done. But just because you can do something doesn’t mean you should. And this idea definitely goes in the “shouldn’t” category.
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Statistically, very few people actually use their 401(k) to buy a house. In fact, only 7% of all down payments were made by tapping into a 401(k) in 2021—including 10% of first-time home buyers and 6% of repeat buyers.1 Even in this world of crazy spending habits and buy now, pay later schemes, most people recognize that using your 401(k) to buy a house isn’t a good idea.
But since you want to know, here are the two main ways it’s done—but they’re both bad ideas.
Early or Hardship Withdrawal
An early withdrawal is taking out the money in your 401(k) before you’re ready (or old enough) to retire—which the IRS has determined to be 59 1/2 years of age. It’s like withdrawing money from your bank account . . . except it’s much more complicated and expensive.
Most plans will allow you to take money out of your 401(k) for what’s called a hardship withdrawal. That means you have to prove to your employer and your 401(k) plan manager that you need the money for something truly financially necessary, like medical expenses, funeral costs or a down payment. But for some plans, putting a down payment on a house doesn’t qualify as a hardship. And the IRS rules don’t find a situation a hardship if you have other ways of paying for the expense, like money from a spouse or child.2 It all depends on your employer’s 401(k) rules.
But even if you’re allowed to take the money out of your 401(k) to buy a house, that’s not the end . . . not by a long shot. There are fees and taxes involved, and they’re pretty hefty.
If you take money out of your 401(k) before you’re 59 1/2, you’ll be hit with a 10% early withdrawal penalty. There are exceptions, but they’re very specific (death, permanent disability, dividing assets after divorce, etc.)—and buying a house ain’t one of them.3 That stinks. But don’t worry, it gets better . . . for the government.
Now we get into income taxes. That’s right—everyone’s favorite topic. You might remember that when you and your employer put money into your 401(k), it was deducted from your paycheck before taxes so the money could grow tax-free. It’s a really great system . . . if you leave the money in your 401(k). But when you take money out of your 401(k), it’s subject to those old reliable federal and (depending on your state) state income taxes. There’s a mandatory 20% federal tax withholding on early 401(k) withdrawals right off the bat.4
So let’s say you want to take $80,000 out of your 401(k) to make a 20% down payment on a $400,000 home. You might feel like you found a shortcut to homeownership by taking money out of your 401(k), but $24,000 of that $80,000 will get eaten up in taxes and penalties before you can even spend it. Poof! You’ll have to take more out just to cover everything if you still want to put 20% down.
And by the way, depending on your annual income, the amount you withdraw, and your state’s tax rates, your giant withdrawal to make that down payment will most likely bump you up into the next tax bracket (maybe two), which means a higher tax bill for you for the year.
Those fees and taxes are bad enough—but the damage doesn’t stop there. The worst part of taking money out of your 401(k) to buy a house is losing the long-term growth on the money you stashed away for your retirement. Compound growth is a wonderful thing, and it’s what turns a few thousand dollars’ worth of contributions from you and your employer into millions over time. Taking that money out of your 401(k) means you’re unplugging it from that potential. And you’ll lose out on some serious money in the long run.
The second way to use your 401(k) to buy a house is even worse than the first: a 401(k) loan. It’s debt—debt made against yourself and your future. It’s such a bad idea that not every 401(k) plan even allows you to take out a loan.
With a 401(k) loan, the IRS limits how much you can borrow for a down payment: Up to $50,000 or half the amount you have in your 401(k) account—whichever is less. Depending on the plan, you could have up to 25 years to pay it back—with interest, of course.5
On the surface, a loan might strike you as a smarter way to go. You’re borrowing from yourself, so the interest you pay essentially goes back to you and not some bank. So long as you keep making payments, you won’t have any penalties or taxes to deal with.
But guess what? It’s not the smart way to go. In fact, it’s pretty stupid.
For one thing, that 5–7% interest you’ll be paying yourself is usually nowhere close to the long-term return of 10–12% you could get if you left your money in your 401(k) in good growth stock mutual funds. Why in the world would you trade 10–12% for 5–7%? That seems nuts, right?
But here’s something even nuttier. If you get fired, laid off, or leave your job before you pay off the loan, you’ll have to pay the balance in full before the federal tax deadline the following year (which we all know is on or around April 15). If you don’t, the government will consider the loan an early withdrawal on your 401(k), and all the taxes and fees that you tried to avoid by taking out the loan in the first place will kick in.6 That means that, as long as you have that 401(k) loan over your head, there’s no freedom to leave your company if, let’s say, your boss is a jerk or you’d just like to move to a more tax-friendly state.
And . . . hello! . . . a loan is nothing but big, fat debt! And debt is dumb. Don’t risk your retirement nest egg over a stupid debt that will take you years to pay off.
Some people might tell you that a loan like this is “good debt”—like a student loan. You’re investing in your future home, after all. Well, we’re here to tell you there is no such thing as “good debt.” Debt robs you of your greatest wealth-building tool: your income. And you can’t use it to build wealth if it’s tied up in debt payments.
Buy a House the Right Way
We’ll give it to you straight: You should never, ever take money out of your 401(k) to buy a house. Period. If you don’t have enough money saved for a down payment, you’re not ready to own a house. Because homeownership comes with all kinds of other costs that could sink you if you’re not financially prepared (HOA fees, emergency repairs, homeowners insurance premiums, etc.).
Leave the money in your 401(k) alone until you’re actually ready to retire. Better yet, work with a SmartVestor Pro to make sure your investments are on track to meet your retirement goals.
The only time (italicized—so you know it’s important) it’s okay to consider taking money out of your 401(k) early is to avoid bankruptcy or foreclosure. But that’s a catastrophic financial situation. Wanting to get into a house faster is not the same thing.
So, if you’ve got the house fever, cool off, take a cold shower, and take a real, honest look at where you are financially. There’s plenty of time and better ways to save up for a down payment. Like we said before, 20% down is ideal because you won’t have to pay private mortgage insurance (PMI) as part of your monthly mortgage payment. PMI is insurance that protects the lender—not you—in case you stop making your monthly payments. Lenders require it for all home buyers who put less than 20% down.
However, a 5–10% down payment will also work—especially if you’re a first-time home buyer. Just be prepared for those PMI payments. And remember, the more you put down, the less you have to borrow—and the faster you can pay that mortgage off and be completely debt-free!
No matter how much you’re putting down, go for a fixed-rate 15-year mortgage with a monthly payment that’s no more than 25% of your take-home pay (including principal, taxes, insurance, PMI and any HOA fees).
Navigating all this can be tricky, so we recommend reaching out to a RamseyTrusted real estate agent. These folks are part of our Endorsed Local Providers (ELP) program, so they’re experts in your local market and can help you find the house that suits your family’s needs and budget. And since they’re RamseyTrusted, you can feel confident they’ll serve you the Ramsey way.