Income tax effects of 401(k) hardship withdrawal to purchase home?

Question

I am in the process of building my first home. My good friend is a CPA and he mentioned to me taking a hardship withdrawal from my 401k when I close on my house after it is built.

He tells me that the penalties I have to pay from withdrawing the money will be washed out by the additional taxes/interest I pay on the home.

Is this a viable option? By doing this I will be able to put down 20% so I don't have to pay PMI. I would be able to withdraw about $40,000.

Also, how will this affect my taxes? I am worried that if I do this I might get in trouble or have to pay penalties. I would love some advice because I need to know if I should contribute more into my 401k or less.

Answer 1

Generally if you need to tap into your retirement for the house - you probably shouldn't buy the house. But that's your call.

There are several things you could do.

1. Sue your CPA "friend" for malpractice. Especially if there's any actual proof of that stupid suggestion.

2. Check with your 401k administrator about home-purchase loan from the 401k. You'll be borrowing your own money, and repaying yourself back with interest, but it will be tax free and with no penalties. Keep in mind: if you cannot repay the loan, or you leave your employer without repaying it in full - the remaining balance will be considered withdrawal and you'll pay income taxes + 10% penalty on it.

3. If you have an IRA, you can withdraw up to 10K without penalty if this is your first house (i.e.: you didn't own a house in the last 3 years), and is going to be your primary residence. You'll still pay taxes on the 10K. But, this is not available for 401k plans.

4. You can request equal payments distribution calculated based on your life expectancy (This is the infamous 72(t)(2) distribution, even though many of the exceptions are in the IRC 72(t)(2). This in particular is 72(t)(2)(A)(iv)).

Here's the full list of exceptions.

Note that even if you're willing to pay the 10% penalty, many 401k plans do not allow distributions as long as you're still employed with the sponsoring employer.

If you take a hardship distribution from your 401k (if it even allows it), you'll be prohibited from contributing for 6 months, and your employer will be prohibited from contributing on your behalf as well. I.e.: not only you take out your savings, you'll be barred from saving back.

Also, in the same FAQ, it tells you that the hardship distribution can only include the amounts up to the original contributions (less whatever distributions already made), and not earnings or match. I.e.: it may actually be much less than the 40K you're counting on.

Answer 2

Unless you have an actual hardship (bankruptcy or other emergency), you will be better off leaving that money alone. This excellent answer, gives more than enough reasons why a withdrawal or loan is not recommended.

I would love some advice because I need to know if I should contribute more into my 401k or less.

If your priority to purchase is high enough, it may be worth considering stopping 401k contributions for a short time to help pile up a down payment.

• This is highly preferable to the other options (401k withdrawal or loan)
• Consider if you are receiving a matching contribution from your employer. If this is the case, I won't recommend passing up free money. Contribute enough to get the maximum match and no more until have saved your down payment.
• If it will take you more than a few years to save up this sum, then this might not be a good option. This depends on your situation and goals.

I also encourage you to consider that if you cannot pool the money from non-retirement sources, then you cannot afford that much house at this time. This might mean looking for cheaper houses or delaying purchase for a number of years.

Answer 3

I'll be happy to edit when you provide answers to the question I posed in the comments.

Given the choice (and I assume there is no other) I'd take a loan from the 401(k) vs a withdrawal.

You withdraw $40K. I'll assume 25% bracket as you're planning at least a $200K house. Hopefully, your taxable income is above $38K, the 25% line for singles. The tax and penalty is 35% total, federal. You net $26K. And you have $40K less in the retirement account. In 40 years, at 10% average growth, that's $1.8M you won't have in your 401(k). And as littleadv stated, no deposits for 6 months, meaning no matching. There's a few more thousand you'll lose.

You borrow $20K. Your 401(k) will see a return on the $20k that's better than the short bond account, 4-5% vs less than 1%. You are short $6K, but in return have paid no tax, no penalty, etc. I respect those who are strongly anti-loan, but even they would agree, this is the far lesser of 2 evils.

The above is pretty generic, there are better choices. But your CPA friend's advice is nearly as bad as it gets. By the way, the tax you'll save once you have the mortgage has nothing to do with that 10% penalty. Say you bought the house with cash (as many would be happy to do). You'd pay the penalty for the 401(k) withdrawal, but have no mortgage deduction. If you had the 20%, you still have a loan and the deduction, but no penalty for taking his bad advice.

My advice is to take that refund and use it to pay the loan faster.

Answer 4

This is a purely numerical statement that you should be able to check (and you CPA friend should be able to prove, if true). The general advice, I think, is that you should not use your retirement funds this way, but general advice does not apply equally well to everyone.

You didn't give enough information for us to compute the answer, so you're on your own there. If you do this (or have the CPA do it), make sure that it accounts for all pluses and minuses that you'll have. On the minus side, you get any direct penalties in addition to potential loss of right to contribute for a period of time, so make sure you consider both aspects, especially to any degree that you would lose an employer contribution or match. Also consider the fact that the money already in is tax advantaged, and you won't be able to replace that amount later. So there will be a compounding effect to what was lost. (This may or may not be balanced by a mortgage interest deduction down the road - My guess is that it will not, but, again, the details of your situation may dictate a different path. The mortgage interest deduction decreases each year as you pay more principal whereas the compounding from being tax deferred tends to increase each year.)