401(k) Loan or Hardship Withdrawal for a Home: What Differs

Buying a home often requires more cash than a household has on hand, and a workplace retirement account can look like a nearby source. There are two main ways to reach that money while still working. One is a plan loan. The other is a hardship withdrawal. The most important difference is that one is meant to be paid back and the other is not.

Key takeaways

• A plan loan is repaid to the account, while the IRS says a hardship distribution is not repaid to the plan and permanently reduces the balance.
• The IRS lists costs directly related to buying a principal residence as a hardship reason, but plans are not required to offer hardship withdrawals.
• A hardship withdrawal is generally taxable income and may carry an additional tax on early distributions, and it cannot be rolled over.
• In a hypothetical comparison, raising $40,000 after an assumed 32 percent in taxes would take roughly $58,800 withdrawn, versus a loan payment near $811 a month.
• Rules differ by plan and may change, so confirming current terms with the plan administrator and a tax professional comes first.

The difference in one sentence

According to the Internal Revenue Service, a plan loan is repaid to the plan, while a hardship distribution is not repaid and permanently lowers the account balance. Everything else in the comparison follows from that.

How a plan loan works

The IRS explains that a plan may limit loans to the lesser of two amounts: the greater of $10,000 or half the vested balance, or $50,000. Loans generally must be repaid within five years in substantially equal payments made at least quarterly. A loan used to buy a principal residence may be repaid over a longer period.

Loans are a plan feature, so each plan sets its own terms within these limits. A separate article on borrowing from a 401(k) for a down payment goes through how loans work in more detail.

How a hardship withdrawal works

The IRS lists costs directly related to buying a principal residence, excluding mortgage payments, as a reason that counts as an immediate and heavy financial need. Plans are not required to offer hardship withdrawals, and a plan can limit which reasons it accepts.

Several features set a withdrawal apart:

• It is not repaid to the plan, so the money leaves the account for good.
• It is generally taxable income, unless it consists of designated Roth contributions.
• It may carry an additional tax on early distributions. The IRS states that rate as 10 percent.
• It cannot be rolled over into an IRA or another plan.
• The amount cannot exceed the need, though the IRS says that need may include money to cover the taxes and penalties the withdrawal creates.

The IRS also says the plan administrator may choose whether to require an employee to obtain a plan loan first, so plans vary.

A hypothetical comparison

Suppose a household needs $40,000 toward a down payment.

With a loan, borrowing $40,000 at an assumed 8 percent over five years means a payment of about $811 a month and about $8,663 in total interest. Each plan sets its own rate, and where the interest goes depends on the plan.

With a hardship withdrawal, taxes enter the picture. If, purely for illustration, income tax and the additional tax combined to 32 percent, the household would need to withdraw roughly $58,800 to keep $40,000, which leaves about $18,800 going to taxes. Nothing is repaid, so the account is $58,800 lower for good.

These figures leave out state taxes, the household's actual bracket, the plan's fees, and the growth the borrowed or withdrawn money might otherwise have earned. They are meant to show the shape of the trade-off, not predict a result.

What happens when employment ends

The loan route carries its own risk. The IRS describes a plan loan offset, where the unpaid loan balance reduces the account and is treated as an actual distribution. Unlike a defaulted loan, an offset may be eligible for rollover. For an offset caused by leaving a job or the plan ending, the IRS says the deadline to roll it over is the due date of that year's tax return, including extensions. A loan that goes unpaid in other ways is generally treated as a taxable deemed distribution, which cannot be rolled over.

Questions to ask first

1. Does my plan offer loans, hardship withdrawals, both or neither?
2. Does it require a loan before a withdrawal?
3. What are the repayment term, rate and fees for a loan?
4. What happens to a loan if I leave the employer?
5. What would the tax cost of a withdrawal be, given my situation?
6. How would my mortgage lender treat either choice?
7. Are there other sources of down payment funds that I have not compared?

Rules in this area can change, and plan documents control what a given plan allows. The plan administrator and a tax professional can confirm current terms before any decision.

Common questions

Can I take a hardship withdrawal from my 401(k) to buy a house?

Only if your plan allows it. The IRS lists costs directly related to buying a principal residence, not including mortgage payments, as a category that qualifies as an immediate and heavy financial need, but plans are not required to offer hardship distributions.

What is the difference between a 401(k) loan and a withdrawal?

A loan is repaid to the plan on a schedule. The IRS says a hardship distribution is not repaid, is generally taxable, may be subject to an additional tax on early distributions, and cannot be rolled over.

What happens to a 401(k) loan if I leave my job?

The IRS describes a plan loan offset, where the unpaid loan reduces the account balance and is treated as an actual distribution. For offsets tied to leaving employment, the rollover deadline is the due date, including extensions, of that year's tax return.

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