Can I withdraw funds penalty free from my 401(k) plan to purchase my first home?

If you are under the age of 59 1/2, you cannot withdraw funds from your 401(k) plan to purchase your first home without being subject to a 10 percent additional tax on early distributions from qualified retirement plans. However, depending on the rules for your 401(k) plan, you may be able to borrow money from your 401(k) plan to purchase your first home. Your plan administrator should have written information about your particular plan that explains when you can borrow funds from your 401(k) plan as well as other plan rules.

References:

• Publication 575, Pension and Annuity Income
• Publication 560, Retirement Plans for Small Business
• Tax Topic 424, 401(k) Plans
• Tax Topic 558, Tax on Early Distributions From Retirement Plans

If I can't withdraw funds penalty free from my 401(k) plan to purchase my first home, can I roll it over into an IRA and then withdraw that money to use as my down payment?

Yes, if you are receiving a distribution from a 401(k) that is eligible to roll over into a IRA and you meet all of the qualifications for an IRA distribution for a first-time homebuyer. Your plan administrator is required to notify you before making a distribution from your 401(k) plan whether that distribution is eligible to be rolled over into an IRA. To see if you qualify for a distribution to be used as a first-time homebuyer, refer to Chapter 1 of Publication 590, Individual Retirement Arrangements (IRAs).

References:

• Publication 560, Retirement Plans for Small Business (SEP, Simple, and Qualified Plans)
• Publication 575, Pension and Annuity Income
• Publication 590, Individual Retirement Arrangements (IRAs)
• Tax Topic 424, 401(k) plans
• Tax Topic 558, Tax on early distributions from retirement plans
• Tax Topic 412, Lump-sum distributions

http://www.irs.gov/taxtopics/tc557.html

Topic 557 - Tax on Early Distributions from Traditional and ROTH IRAs
 

To discourage the use of IRAs for purposes other than retirement, the law imposes an additional 10% tax on early distributions from traditional and Roth IRAs unless an exception applies. Generally, early distributions are those you receive from an IRA before reaching age 59 1/2.

Distributions that you roll over to another IRA or qualified retirement plan are not subject to this 10% additional tax. For more information on rollovers, refer to Topic 413.

There are exceptions to this additional tax for early distributions that are:

• made to a beneficiary or estate on account of the IRA owner's death,
• made on account of disability,
• made as part of a series of substantially equal periodic payments over your life or life expectancy,
• made to pay for a qualified first–time home purchase,
• not in excess of your qualified higher education expenses,
• not in excess of certain medical insurance premiums paid while unemployed,
• not in excess of your unreimbursed medical expenses that are more than a certain percentage of your adjusted gross income, or
• due to an IRS levy.

Refer to Publication 590, Individual Retirement Arrangements, for more information on these exceptions.