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Should You Tap Your 401(k) to Fund Your Down Payment?

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Dear Carrie: My husband and I are trying to scrape together enough money for a down payment on our first home. Because we live in an expensive real estate market, we need to be creative and consider all our potential resources. Would it be OK if we borrowed from our 401(k)s? -- A Reader

Dear Reader: How exciting that you're buying your first home! I know how hard it can be to come up with a down payment in an expensive market, so this is a great question.

The traditional financial advice has long been, "Never take an early withdrawal from retirement savings," and I generally agree. One exception, however, might be exactly the situation you describe. Why? For two reasons. First, because you're taking a loan rather than a permanent withdrawal. Second, because you're using the money to buy a first home, which can be a challenging -- but ultimately worthwhile -- financial goal.

That said, you need to proceed with caution. A study by TIAA found that nearly a third of Americans who participate in a retirement plan have taken out a loan from it, and 44% regretted it. So, if you want to borrow from your 401(k) without regret, it's best to understand how such loans work, as well as the benefits and risks involved.

The Basics

First, not all 401(k) plans allow loans. Even if yours does, every 401(k) plan limits how much you can borrow: one-half of the vested value of your account or a maximum of $50,000, whichever is less. If both you and your spouse have $100,000 or more in separate accounts, you're eligible to borrow $50,000 each, for a total of $100,000 -- a big chunk toward a down payment.

 

The repayment period is typically five years, although that can vary by plan and may not apply if the loan is used to purchase a home. Repayment options usually include regular deductions from your paycheck or a lump sum by a specific date, and there's no penalty for repaying the loan early.

In general, I recommend you pay back the entire amount as soon as possible, preferably in three years or less. No matter which option or time frame you choose, it's important to create a repayment schedule and stick to it.

Revisit your budget and make this a line item. If you miss even one payment, the loan could be recategorized by the IRS as a "distribution," which means you would have to pay federal income tax on the loan amount, plus a 10% early withdrawal penalty if you're under age 59 1/2.

The Potential Benefits

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