When saving up to buy a home, a down payment can be a looming expense that intimidates or turns away buyers. For those who find the task of saving for a down payment insurmountable, pulling money out of a 401k or IRA to make a down payment could make it easier to buy a home. Here's what buyers need to know before they prepare to make a withdrawal.

For informational purposes only. Always consult with a financial advisor before proceeding with any real estate transaction.

How 401k Withdrawals Work

People are not really encouraged to withdraw from a retirement plan before they get close to retirement age. However, there are a number of ways that people may be able to do it. Anyone pulling money out of a retirement account may be subject to a 10 percent penalty on the withdrawal. Depending on the type of retirement account, they may also be required to pay income taxes on the distribution. The reason for this is that 401k plans and some other retirement programs are tax-deferred. This means that people can contribute to the plan using pre-tax income, and just pay taxes once they take a withdrawal.

401k vs IRA Withdrawals

Before buyers get too invested into their ability to take money out of a retirement plan, they must understand how a 401k withdrawal works differently from an independent retirement account (IRA). People who put money into a Roth IRA are using their after-tax dollars to do so. They are allowed to withdraw their contributions anytime they like, with no penalty. If they have held the account for five years, they may also be able to avoid a penalty on the earnings. Even withdrawing from a traditional IRA may allow a first-time home buyer to bypass the penalties on up to $10,000. However, these options usually do not apply to 401k withdrawals.

401k Loans

Since the 10 percent penalty for early withdrawals and tax liability can take a fairly big bite out of the total, some people decide to take out a loan against the 401k instead of a withdrawal. In this case, the buyer is permitted to borrow as much as $50,000 or half of the value of the 401k savings, whichever is less. Even though the applicant is borrowing from their own account, it is still considered a loan with a regular monthly payment. The loan term is set with a specific end date, usually no more than five years.

The Expense of Opportunity Cost

Anytime people decide to dip into their retirement to pay for something now, they should consider the opportunity cost. First, the penalty and tax liability could eat up as much as a third or more of the withdrawal, forcing people to withdraw even more to make it worth the effort. Second, they must think about how they will ensure enough money for retirement despite the withdrawal. People who pull out much or most of their retirement savings to buy a home need to develop a plan to replace those funds and the loss of potential earnings from them.

Benefits of Withdrawing Money From a 401k

Of course, buying a home can secure a different kind of investment that people can use as they approach retirement. Sometimes, being able to get through the door of buying a home calls for extra help for the down payment. Buyers who cannot get assistance from family members must plan to either save the money separately, or call on other savings they already have to close on a home. Thinking of 401k withdrawal as an option may allow people to buy a home at a more ideal time.

When is it the Right Decision to Pay for Your Down Payment With Your 401k?

For individuals struggling to come up with a down payment for a home, it can be beneficial to take some money out of a 401k and use it for the down payment. Take the time to figure out how much can be taken out without a penalty, and consider the long term consequences of taking money out of a retirement account. Additionally, it's important to evaluate the real estate market to determine if the investment value of a home is greater than the investment value of the money staying in your 401k. If the market is slow or it's suspected that the real estate in your area is in a housing bubble, you may lose a substantial amount of money by putting the money towards a home instead of towards your retirement.

If the rental market is bad, prospective homeowners may consider turning to the housing market to ease their financial troubles. People who are paying a high rent should invest in a property they can afford, even if it means using some 401k funds for the down payment. If possible, figure out a payment plan to replace the money so that long term the retirement funds aren't seriously impacted.

However, homeowners should look into other down payment options before withdrawing from their 401k to buy a home. Some home loans, such as the FHA home loan, offer a down payment requirement as low as 3.5 percent, while the VA home loan allows home buyers to make a purchase with no down payment at all. For home purchases where less than 20 percent of the home's value is paid up front in a down payment, homeowners are expected to pay private mortgage insurance (PMI) to offset the risk to the lender, but this cost may be less than the loss of money that would have been generated by leaving money in your retirement accounts to collect compounding interest.

The down payment is often the biggest expense for a Brentwood home buyer, and the money has to come from somewhere. With a better understanding of these limitations and benefits, buyers can make an educated decision about their down payment funding options.

For informational purposes only. Always consult with a financial advisor before proceeding with any real estate transaction.