Advisors raise red flags at proposal for penalty-free 401(k) withdrawals

A plan proposing penalty-free withdrawals from 401(k)s for home buying is fraught with risks, warn financial advisors, citing a psychological shift in how people will perceive their retirement accounts.  

Talk of potential changes to 401(k) withdrawals has been swirling for weeks. Set against this backdrop, Republican Rep. John McGuire recently introduced a bill that would remove penalties for withdrawals from a 401(k) when the money is used for closing costs and down payments for home purchases. In a statement, McGuire said that the bill would pave the way for removing financial barriers to home ownership.

Bob Ruelle, senior vice president of financial planning at Apollon Wealth Management, thinks that a shift in 401(k) withdrawals would lower “the psychological barrier” to tapping retirement assets for non‑retirement goals. “I think you would see clients mentally reframe their 401(k) from ‘untouchable retirement capital’ to ‘flexible life-planning capital,’" he told InvestmentNews. “Once a withdrawal is labeled ‘penalty‑free,’ many clients interpret that as an implicit endorsement—even if the long‑term cost is substantial.”

“I imagine that clients may ask whether they should do it—they’re asking why they wouldn’t,” he added.

Generally, the money that a person withdraws from a retirement plan or an IRA before reaching the age of 59-and-a-half are defined as “early” or “premature” distributions, according to the IRS. Individuals, the government tax agency notes, must pay an additional 10% withdrawal tax unless an exemption applies.

Robert Gorman, founding partner and chief development officer at Apollon Wealth Management, warns that, from a financial planning standpoint, people should be careful not to confuse account structures with financial goals. “A 401(k) is fundamentally designed to accumulate savings for retirement security, not to serve as a primary source for major non-retirement purchases such as a home,” he told InvestmentNews. “The risk with proposals that allow penalty-free 401(k) withdrawals for down payments is that they risk normalizing the idea that retirement assets are an acceptable first stop for liquidity, when in fact doing so can materially reduce long-term outcomes.”

McGuire’s Home Savings Act would amend the Internal Revenue Code of 1986 to allow permit-free withdrawals from a 401(k) account for up to five years when the funds are used for a down payment or closing costs on a primary residence. The Act also lets an individual make a penalty-free 401(k) withdrawal and gift those funds to a relative, exempt from gift tax, on the condition that the relative uses the money for a down payment or closing costs on a primary residence. As McGuire explained in his statement, the Act is “ending a cycle of throwing away money in renting and helping young people invest in their future."

But Gorman says we’re potentially seeing another example of financial incentives that reward short-term gratification over long-term results. This, he adds, is a theme showing up in other parts of the financial ecosystem, such as the gamification of investing or speculation via emerging market trends like betting on binary outcomes on Polymarkets. “Long-term investing by definition requires discipline and a horizon that extends well past the next purchase or headline,” he said. “There's a difference between investing and speculation.”

He also cautions that planning a home purchase should be thoughtful, with clear timing expectations and an appropriate risk allocation strategy. “For someone early in their career who chooses an aggressive investment allocation on the assumption they’ll tap their 401(k) in the next 4–8 years, there’s significant sequence-of-returns risk—especially if a market downturn occurs shortly before a planned withdrawal,” he said. “In that scenario, the cost isn’t just the taxes on the distribution but also the lost opportunity to participate in a subsequent market recovery.”

“Ultimately, expanding permitted 401(k) uses without careful framing and guidance risks shifting behavior inside plans in ways that diminish retirement outcomes in pursuit of near-term goals,” Gorman added.

National Economic Council Director Kevin Hassett discussed a plan to tap 401(k)s earlier this year although President Donald Trump recently reporters that he’s “not a huge fan” of the idea. “One of the reasons I don’t like it is that their 401(k)s are doing so well,” he added, when addressing reporters on the way back to the U.S. from the World Economic Forum in Davos last month.