401(k) Loans

• Individuals who can take out loans from a 401(k) plan must do so rather than make a withdrawal. The IRS only allows individuals to make withdrawals if loans are unavailable in a plan or if they have already borrowed the maximum that their plan permits. These 401(k) loans are not taxable events because the plan participant repays the amount of the loan through pre-tax contributions. The interest paid on a 401(k) loan goes into the borrower's own 401(k) account and not to a third party. However, some people cannot afford to make large monthly payments which makes 401(k) loans an unattractive option for some.
  
  

401(k) Loan Restrictions

• As of 2010, the IRS allows individuals to withdraw the lesser of 50 percent of their vested 401(k) balance or $50,000 for use as a down payment on a first time home purchase. Vested balances are the funds in a 401(k) account that actually belong to the employee at the time of the withdrawal. The individual's own contributions are immediately vested, but company contributions are not always vested at the time of contribution. Plans vary, but some company contributions only become vested after 12 months or more.
  
  

Taxation

• A 401(k) account is a tax-deferred retirement account, and individuals who make premature withdrawals from these accounts, including withdrawals to make a first time home purchase, must pay a 10 percent tax penalty. Premature withdrawals are defined as those made by individuals under the age of 59-1/2 or plan participants who have held the account for less than five years. Additionally, the plan custodian must withhold 20 percent of the withdrawal amount to cover income taxes although the IRS may adjust this amount at tax time.
  
  

Misconceptions

• Some people believe that you can make penalty-free withdrawals from 401(k) accounts to buy a first time home. In reality, you can only make such withdrawals from Roth Individual Retirement Accounts and not 401(k) accounts or other types of IRAs. Roth accounts are funded with taxed earnings so the withdrawals are not subject to income tax, and the IRS waives the 10 percent penalty. An individual can withdraw no more than $10,000 from a Roth, tax-free, within a single tax year.