A Shaky Foundation

Should I make an early 401(k) withdrawal to buy a house? What if I just borrow from the account instead?

In all likelihood, your employer will allow you to tap your 401(k) to purchase a home. Just keep in mind that if your employer allows both borrowing and withdrawals to take place (most large employers do), the rules typically require that you borrow first. Of course, the bigger question here is whether it makes sense to do either one. For most folks, it probably doesn't.

First, let's talk about borrowing. Nearly 88% of employers allow employees to borrow from their 401(k) plans, according to the most recent survey by the Profit Sharing/401(k) Council of America (PSCA). In most cases, an individual is allowed to tap up to $50,000 or 50% of their vested funds, whichever is lesser. Employees usually have a minimum of five years to pay the money back at an interest rate of 1% to 2% above the prime rate, which is currently 5.5%. (For home purchases, however, the duration of the loan can often be extended to 10 years or longer.) Best of all, those interest payments go straight into your retirement account — so, as you mention, you're "paying yourself back."

There are, however, a couple of drawbacks. For starters, when you borrow the money you're taking out pretax dollars, but when you repay the loan, you'll be using posttax money. When you're ready to tap into your account for retirement, those same dollars will then be taxed again as ordinary income.

Worse yet, should you leave your company for any reason before you pay back the loan, you'll most likely have to pay off the balance immediately. If you don't, you'll be saddled with federal and state (where applicable) tax bills plus a 10% penalty if you're younger than 59 1/2. The same goes if you miss a payment, warns certified financial planner Stewart Welch of Birmingham, Ala.

"Mess this one up and you'll find yourself in a spot you don't want to be in," Welch says. "If you miss a mortgage payment, a bank will at least work with you. Miss this one and you get a tax bill." Complicating matters, some people find they have to borrow more money just to pay the taxes. Despite the risks, the planners we spoke with said that borrowing from your 401(k) is better than taking a permanent withdrawal, which is probably why most employers force you to first borrow funds before permanently tapping your account. Of course, if you need more than half of your vested balance or $50,000, then you might be tempted to withdraw additional funds to make up the difference. Nearly 91% of employers allow their employees to take what's called a "hardship withdrawal," according to PSCA's president David Wray — which can include buying a home. Typically, hardship withdrawals are permitted only once the employee has shown that all other sources of funding have been exhausted.

The problem with taking a withdrawal — as mentioned previously — is that you'll have to pay federal and state (where applicable) taxes on the money, as well as a 10% penalty if you're under 59 1/2. If that weren't bad enough, most employers won't allow you to make contributions to your 401(k) for the following six months. And even if you can afford it, you aren't allowed to repay the money. So not only are you draining your account, but you're also forfeiting future tax-advantaged savings and your employer's match, to boot.

So does it ever make sense to tap your 401(k) to buy a home? Perhaps. If it's the only way you can swing the purchase, the move is worth considering — but only if you're borrowing from the account, says Steven Kaye, a certified financial planner based in Watchung, N.J. A home, after all, is usually an appreciating asset, and it offers annual tax deductions. "Sometimes we have to sacrifice some tax benefits to have recurring tax benefits," he says. "It's a one-time entry fee to get continuing deductions."

Still, financial planners agree that there are better ways to buy that home. Welch even prefers that people put down just 5% or 10% of the purchase price and pay private mortgage insurance. For some suggestions on better ways to come up with a down payment, read our story.