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Not saying this is a good idea, but honestly it was something I was just curious about.

My and other 401(k) plans allows you to withdraw from your 401(k) before 59 years of age for "hardship" for the purchase of first home. But what if you did that and then the home purchase fell through or someone decided to just buy a car with it? (Obviously a terrible idea.)

I've seen people do this on forums. Wouldn't that be illegal? I mean obviously the 10% penalty would come into play.

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    For first-home buyer distributions from IRAs, if the deal falls through, you can return the money to the IRA within 120 days of the withdrawal without any penalties etc. It is treated as a rollover contribution to an IRA, and there are no tax consequences. If you don't meet the deadline (or buy a car instead), then penalties apply etc. I don't know whether the same rule applies to all 401k plans or if it is an option that can be chosen by the employer when setting up the plan. If the latter, you need to ask your 401k plan administrator. – Dilip Sarwate Sep 11 '14 at 15:10
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IANAL but I'd think common sense would say that if you take advantage of one of the special cases that allow you to withdraw from a retirement plan without penalty, and then for whatever reason you don't use the money for a legal purpose, you would have to either return the money or pay the tax penalty. And I'll go out on a limb here without any documentation and guess that if you lie to the IRS and say that you withdrew the money for an exempt purpose and instead use it to go on vacation and you get caught, that you will not only have to pay the tax penalty but will also be liable for criminal charges of tax fraud. If the law and/or IRS regulations say that the only legal exceptions are A, B, and C, that pretty clearly means that if you do D, you are breaking the law. And in the eyes of the government, failing to pay the taxes you owe is way worse than robbery, murder, or rape.

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Take some of the commentary on home buying forums with a grain of salt. I too have read some of the commentary on these forums such as myFICO, Trulia, or Zillow and rarely is the right advice given or proper followup done.

Typical 401k withdrawals for home purchase would not be considered a hardship. However, most employer 401k plans will allow you to take a loan for 401k as long as you provide suitable documentation: HUD-1 statement, Real Estate Contract, Good Faith Estimate, or some other form of suitable documentation as described by the plan administrator.

For instance, I just took a 401k loan to pay for closing costs and I had to provide only the real estate contract. Could I not follow through with the contract? Sure, but what if I am found out for fraud? Then the plan administrator would probably end up turning the distribution into a taxable distribution. I wouldn't go to jail in this hypothetical situation - I am only stealing from myself. But the law states that certain loan situations are not liable for tax as long as that situation still exists. In the home loan situation, my employer allows for a low interest, 10 year loan.

My employer also allows for a pre-approved loan for any purpose. This would be a low interest, 5 year loan.

There is also the option to not do a loan at all. But normally that is only allowed after you have exhausted all your loan options and the government makes it intentionally harsh (30% penalty at least) to discourage people from dumping their tax free haven 401k accounts.

That all being said, many plans offer no prepayment penalty. So like my employer has for us, I can pay it all back in full whenever I want or make micropayments every month. Otherwise, it comes out of my pay stub biweekly. So if it were to fall through, I could just put it all back like it never happened. Though with my plan, there is a cooling off period of 7 days before I can take another loan.

Keep in mind that if you leave your employer then the full amount becomes a taxable distribution unless you pay it back within a certain period of time after leaving the employer.

Whether this fits your financial situation is up to you, but a loan is definitely preferred over a partial or full withdrawal since you are paying yourself back for your rightly earned retirement which is just as important.

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