Tap your 401(k) to buy or remodel a home?

If you're years or even decades away from retiring, you may be eyeing your 401(k) and dreaming of how you could use that money now for a down payment on a house or a kitchen remodel. The rules vary from one 401(k) to another -- how much you can withdraw or borrow; for what purpose, and repayment requirements for taking out a loan. In addition, you may face tax consequences for a withdrawal.

Retirement savings withdrawal rules for homebuyers

If you are a first-time homebuyer, defined as someone who has not owned a home in the two years prior to purchasing a home, you may qualify for a reduction in taxes on a retirement savings withdrawal. If you are older than 59 ½, you can withdraw funds without an early withdrawal penalty.

Early withdrawals: what are the tax penalties?

• No penalty on a 401(k) withdrawal if you pay it back within the allotted time period. If you don't pay it back, you'll pay a 10 percent early withdrawal penalty and regular income taxes on the withdrawal amount
• Some 401(k) programs allow a first-time homebuyer to withdraw a "hardship distribution" for down payment funds. This distribution cannot be repaid and can only come from contributions to the fund, not interest earnings. You may be subject to pay both a 10 percent penalty and income taxes on this distribution
• No penalty or taxes on your contributions (not including the interest earned) to a Roth IRA for a withdrawal for any reason or at any age
• No penalty on earnings from a Roth IRA if you are a first-time buyer on up to $10,000 for each spouse, but the funds withdrawn are considered taxable income. However, if you've had the account for at least five years, you can avoid taxes on the withdrawal
• For first-time homebuyers, there is no penalty on a traditional IRA withdrawal of up to $10,000 per spouse, but the withdrawal is subject to tax

Borrowing from your retirement savings

You can't borrow and replace any funds from either a traditional IRA or a Roth IRA. Those funds are simply considered a withdrawal rather than a loan. However, if your employer allows it, you can borrow money from your 401(k) for any reason, including a down payment for a house or to fund a home improvement project. Most 401(k) programs allow you to borrow up to $50,000 or half of your vested balance, whichever is less. You won't pay taxes on the withdrawal since it is a loan, but you will be required to repay the loan.

401(k) loan terms:

• Repay within five years, although repayment of a loan for a home purchase may be extended.
• Loan repayment must be made at least quarterly over the life of the loan
• If you don't repay the 401(k) loan on time and you are under 59 ½, you'll pay a 10 percent penalty and regular income tax on the withdrawal.

Pros of borrowing from your 401(k)

• Borrowing money from yourself and repaying yourself. Your interest payments go into your own retirement account rather than the pockets of a financial institution
• Interest rates far lower than a credit card or a personal loan
• No restrictions on use of the funds you borrow, so you can use the money for any type of home improvement project even after you have bought a new home or if you are a long-time homebuyer

Cons of borrowing from your 401(k)

• Reduction in your retirement savings
• Loan repayment could impact your ability to afford other payments such as your mortgage and other bills
• If you cannot repay the loan and continue to make regular retirement contributions you could lose your employer's matching contributions
• If you lose your job for any reason the full amount of the loan becomes due within 30 to 60 days depending on your plan's rules

In general, the best candidates for borrowing from retirement savings are those who are in their 40s or younger, at least ten to twenty years before retirement so that they can safely rebuild their savings over time. In addition, if you have a plan and a means to repay your 401(k) loan quickly, this low-cost financing could be a good alternative to a high interest credit card loan or a long-term home equity loan.