Getting money out of your 401(k) retirement plan to buy a house without a large tax consequence is a bit tricky, but it can be done. The IRS permits early distributions from certain plans penalty-free. If you need extra cash to facilitate your first home purchase, your savings plans might be a good source to tap.
When you use IRA funds for the down payment of your first house before age 59 1/2, the IRS waives the 10 percent early withdrawal penalty. This exception applies only to distributions from IRA accounts, so you’ll have to roll over your 401(k) funds into an IRA to qualify. Qualified rollovers are generally tax free and not subject to contribution limits, but you must fund the IRA within 60 days of receiving the rollover distribution from your 401(k) plan. Some plan administrators can perform a direct rollover for you -- this reduces the risk of missing important funding deadlines.
You’re eligible to take IRA distributions for house purchases when your new house qualifies as your first one. The IRS defines first-time home buyers as those who have not owned a house within the last three years, so the funds don’t have to be used for your first-ever home purchase. If you’re married, both you and your spouse must meet the three-year rule to qualify.
As of the date of publication in June 2012, you can withdraw up to $10,000 from your IRA to buy a house without incurring early withdrawal penalties. If you’re married and your spouse maintains a separate IRA, your spouse can also withdraw up to $10,000 from her IRA for a total of up to $20,000 that you can use toward your home purchase penalty-free.
Rollover contributions you make to your IRA from your 401(k) plan are subject to income tax upon withdrawal, even when you qualify to take the distribution without penalty. Contributions to 401(k) plans are made pre-tax and are not included in your taxable income when you place the funds in the account. The IRS makes up for this when you withdraw 401(k) contributions. The income tax on your distribution is the same as your tax on all income sources in the year you withdraw. In most cases, your plan administrator will withhold 10 percent of your distribution for taxes, but if you’re taxed in a higher income bracket, the withholding may not be sufficient to cover the bill for your distribution.
If rolling over your 401(k) into an IRA sounds tedious or you don’t qualify as a first time home buyer, ask your plan administrator if you’re eligible to take out a loan against your 401(k). Plans vary, but if you qualify you may be able to borrow up to $10,000 or 50 percent of your vested balance, whichever amount is greater. Amounts you borrow from your 401(k) are not taxable or subject to penalty because you pay the money back. In most cases, you have five years to repay the loan, and the interest you pay on the note is credited back to your retirement account. However, if you lose your job or the company you work for goes out of business, the IRS considers any remaining loan balances as an early distribution. Since 401(k) distributions are subject to income tax and don’t qualify for penalty-free house purchase funds, you could be looking at a large tax bill if you’re out of work before your loan is paid.
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