A 401(k) retirement plan can be tapped to raise a down payment for a house. You can either borrow money or make a withdrawal from your 401(k).
Withdrawing From a 401(k)
The first and least advantageous way is to simply withdraw the money outright. This is treated the same as a hardship withdrawal, meaning that you owe the full income tax as if it were any other type of regular income that year. This can be particularly unappealing if you are close to a higher tax bracket, as the withdrawal is simply added on top of the regular income. There’s a 10% penalty tax on top of that if you are under 59.5 years of age.
Borrowing From a 401(k)
The second way is to borrow from the 401(k). You can borrow up to $50,000 or half the value of the account, whichever is less, as long as you are using the money for a home purchase. The interest rate for this loan is typically two points over the prime rate. You are effectively paying interest to yourself rather than to the bank.
The downside is that you need to repay the loan, and the time frame is normally no more than five years. With a $50,000 loan, that’s $833 a month plus interest. You must disclose this to the bank when you’re applying for the rest of the loan since it could potentially drive up your monthly expenses.
If your employment ends before you can repay the loan, there’s typically a 60- to 90-day repayment window for the full outstanding balance. Failure to repay the loan triggers the regular taxation and 10% penalty tax, as the outstanding balance is then considered to be an early withdrawal.