Borrowing from a 401(k) to Make a Down Payment

It looks like I’m going to need to take money from my retirement savings to make a down payment on a house. Which is better to tap for a down payment -- a 401(k), a Roth IRA or a traditional IRA? Can I avoid the penalties and taxes for withdrawing money if I’m buying a home?

Your best bet is to tap your 401(k). You can generally borrow up to half of your balance, up to a maximum of $50,000, from the account at any age and for any reason without tax or penalty. The interest you pay on the loan (generally the prime rate plus one or two percentage points) goes back into your account.

Loans from 401(k)s usually must be paid back in five years, but your employer may give you up to 15 years to repay a 401(k) loan if you are borrowing the money to buy a home. Your employer will usually start deducting the monthly loan payments from your paycheck right away.

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There is one major drawback to borrowing from a 401(k): If you lose or leave your job, you generally have just 60 to 90 days to pay back the loan or it will be considered a distribution -- and subject to taxes, plus a 10% early-withdrawal penalty if you’re under age 55 when you leave your job.

Taking the money from a Roth for a down payment is your next-best choice. You can’t borrow from the account and return the money to it, as with a 401(k), but you can withdraw up to the amount of your contributions tax-free and penalty-free for any reason and at any age. If you withdraw earnings from a Roth before age 59½, you generally must pay taxes and a 10% penalty; after age 59½, you can withdraw earnings penalty- and tax-free (as long as you’ve had a Roth IRA for at least five years). But if you’re using the money to purchase your first home, you (and your spouse) can each withdraw up to $10,000 in earnings from your Roth IRAs without the 10% early-withdrawal penalty even if you’re under age 59½. You’ll also avoid a tax bill on that withdrawal if you’ve had a Roth IRA for at least a five-year period. If you don’t meet the five-year test, you’ll owe taxes on that $10,000, but not the 10% penalty.

First-home rules are least advantageous for traditional IRAs. You and your spouse can each take up to $10,000 from your traditional IRAs for a first-home purchase without the 10% early-withdrawal penalty, but the withdrawal is still taxable.

You don’t literally have to be a first-time homebuyer to qualify for the first-time-homebuyer exceptions, but you can’t have owned a home in the previous two years. If you already own a home, you can still take the 401(k) loan or withdraw your contributions to a Roth IRA without penalties or taxes, but you won’t qualify for the $10,000 penalty-free IRA withdrawals.

For more information about IRA withdrawal rules, see IRS Publication 590, Individual Retirement Arrangements.