Using Old Employer 401(k) Funds for Owner-Occupied Multifamily Down Payment — Tax Que

[Theresa Strong]

Hi everyone,

I’m helping someone who is under contract on a 3-unit property that will be owner-occupied as their primary residence. They are considering pulling approximately $40,000 from an old employer 401(k) through Empower to use toward the down payment and closing costs for a conventional primary residence loan.

We understand there may be a 10% early withdrawal penalty, but we’re trying to understand the tax side before moving forward.

Questions:

1. If the account has Roth 401(k) and/or traditional 401(k) funds, how is the withdrawal taxed?

2. Is the full withdrawal taxable, or only the earnings/pre-tax portion?

3. Does using the funds for a primary residence help avoid any penalty or taxes, or does that not apply to 401(k) withdrawals?

4. Should federal/state taxes be withheld upfront, or should he plan to pay at tax time?

5. Has anyone used old employer 401(k) funds for an owner-occupied multifamily purchase? What should we watch out for?

We are also waiting to speak with a CPA, but I wanted to ask here to better understand what questions we should be asking before he makes the withdrawal.

Thanks in advance.

[Ashish Acharya]

Hey Theresa! Really smart to be asking these questions before the withdrawal happens rather than after. Let me work through each one.

On the Roth versus traditional question, the tax treatment is different for each. Traditional 401k contributions and earnings are fully taxable as ordinary income when withdrawn since those dollars were never taxed going in. Roth 401k contributions were made after tax so those come out tax free, but the earnings portion is taxable and subject to the 10% penalty if the account isn't yet qualified. If the account has both, the plan documents will determine how the withdrawal is sourced.

On the primary residence exception, unfortunately that exception applies to IRAs, not 401k plans. So using the funds for a home purchase does not exempt the withdrawal from the 10% early withdrawal penalty the way it would with an IRA. That's a really important distinction that catches a lot of people off guard.

On withholding, Empower should withhold some taxes automatically on a 401k distribution, and state taxes may apply on top of that depending on Illinois rules, but you should confirm that with Empower.

One thing worth seriously considering before pulling from the 401k is whether a loan from the plan is available instead. A 401k loan avoids the taxes and penalty entirely as long as it's repaid on schedule, which could be a much cleaner path to accessing those funds for the down payment.

Definitely worth mapping all of this out with a CPA before the withdrawal is processed, especially with the 3-unit purchase closing on the horizon. You want to make sure the tax hit is fully understood and that no better options are being overlooked. Happy to connect!