Archive for Friday, April 21, 2006

Tapping 401(k) for home purchase can be costly

April 21, 2006

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Q: You recently wrote that people can withdraw up to $10,000 from their individual retirement accounts and avoid the usual 10 percent "early withdrawal" penalty if the money is used to purchase their first home. I am 23 years old and don't have an IRA, but I have a company-paid 401(k) retirement plan. Do the same rules that apply to IRAs also apply to 401(k) withdrawals?

A: No. Although the Internal Revenue Service allows first-time buyers to make up to $10,000 in penalty-free withdrawals from their IRAs, it doesn't provide the same tax break to people who tap their 401(k) retirement accounts.

Generally, you cannot make any penalty-free withdrawals from a 401(k) company plan unless you leave the job or have reached the age of 59 1/2. But the good news is that the company may let you borrow against the equity in your 401(k).

Federal law permits employers to allow their workers to borrow as much as 50 percent of the value of their individual plan, up to a limit of $50,000. Some employers allow such borrowing, but others do not. Ask your company's human resources department or retirement-plan administrator if you qualify.

Though 401(k) loans typically carry very low interest rates - sometimes as low as 1 percent or 2 percent - interest payments on the loans cannot be deducted at tax time.

Think carefully before tapping your 401(k) to buy a house. If you leave the company before the money is repaid, the entire balance of the loan could become due and payable in a lump sum. And if you're unable to pay all the money back, you'll have to pay taxes on the unpaid portion of the debt and also could get smacked with a 10 percent early-withdrawal penalty.

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