Avoid Penalty When Using 401(k) to Pay Off House?

Piggy bank

Dear Tax Talk,

My question is about taxes and the 10 percent penalty on my 401(k) withdrawal last year. I lost my job in February, and I did a partial rollover of my workplace 401(k) plan. I used about one-half of the total funds in my 401(k) to pay off the mortgage on my home. I am wondering about tax liability and if I can be exempt from the 10 percent penalty since I used the money to buy my home. Can I avoid the penalty for using my 401(k) to pay off the house? Thanks for any help. -- James

Dear James,

First of all, I am sorry that you lost your job and if you are still in the job market, wish you luck in your search.

Generally, if you are under age 59 1/2, you must not only add this to your gross income, but also pay a 10 percent additional tax on your early distribution. As you are aware, there are exceptions and it seems you have gone down the list and honed in on "distributions of up to $10,000 to buy, build or rebuild a first home." It sounds simple, but of course it is not when you are dealing with the IRS. Now comes the fine print of how the IRS defines that concept.

According to the IRS, to qualify, the distribution must meet all the following requirements:

It is used to pay the qualifying acquisition costs for the main home of a first-time homebuyer. It can be you; your spouse; yours or your spouse's child; yours or your spouse's grandchild; yours or your spouse's parent; or other ancestor. And it gets even better as you are a first-time homebuyer if you had no present interest in a main home during the two-year period ending on the date of acquisition of the home being bought, built or rebuilt.

It must be used to pay qualified acquisition costs before the close of the 120th day after you received it. Qualified acquisition costs include costs of buying, building or rebuilding a home and any usual or reasonable settlement, financing or other closing costs.

In your situation, paying down your mortgage is not going to qualify, but I do understand why you think it should. The IRS would say these are not qualified acquisition costs. You are paying down a loan, and that is not the same thing as buying your home.

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