Many of our borrowers ask us the advisability of using their retirement savings to help pay for a new home. They’ve been been socking away money in their 401(k) retirement account and IRAs, and they’re thinking of using some of that savings toward the purchase of a home.
Generally, taking money out of a retirement account early has some potential tax consequences but the IRS makes some exceptions for prospective homeowners who are dipping their toes in the market for the first time.
Whether you should pull the trigger on using part of your nest egg as a down payment really depends on what type of retirement account you have and how much money you need.
Who qualifies as a first-time buyer?
Obviously, someone who’s never owned a home before is a first-time buyer but the IRS is a little more flexible in its definition. Technically, you can still be considered a first-time buyer as long as you haven’t owned a home in the two years prior to closing on your new property.
Traditional and Roth IRA withdrawal rules
As of 2014, the IRS allows you to withdraw up to $10,000 penalty-free from a traditional or Roth IRA if you qualify as a first-time homebuyer. If you’re married, the limit applies to both of you so you can take out up to $20,000 without having to pay the 10% early withdrawal penalty.
Typically, earnings are subject to income tax but the IRS waives this rule for first-time home-buyers, as long as your account has been open for at least five years. If your IRA has been open for less than five years, you’ll still avoid the penalty but you’ll have to cough up the taxes on the distribution.
Just keep in mind that you have 120 days to use an IRA withdrawal to cover home-buying costs. If you’re still holding on to the money after the deadline, the IRS will consider it to be a regular distribution which means it may be taxable and the early withdrawal penalty will apply.
Borrowing from a 401(k) retirement account
The cost of getting a distribution from your 401(k) retirement account usually outweighs the benefits, since you’ll be on the hook for both taxes and the early withdrawal penalty.
Taking out a loan against your balance, on the other hand, allows you to sidestep the tax implications and you can withdraw quite a bit more compared to an IRA. Currently, you can borrow up to half of the vested benefits in your account, up to a maximum of $50,000.
A 401(k) loan is paid back with interest through automatic payroll deductions so it goes directly back into to your account. How long the repayment period and whether or not you can make new contributions to the plan during this time usually depends on your employer’s preference. Most loans must be repaid within five years, although you may be given up to 15 years to pay it off.
Is pulling from retirement account the right move?
On the one hand, when you are paying back the 401(k) loan, the interest you’re paying is likely to be much less than the returns you would have gotten if you’d left the retirement account money alone. You don’t even get the benefit of the interest with an IRA withdrawal.
On the downside, if you get fired or decide to change jobs the entire loan balance may be due with a short time. If you can’t pay it back when your ex-employer requires it, you’ll have to report all of it on your taxes. This means you’ll have to pay the early withdrawal penalty on top of a potentially hefty tax bill. Ask your human resources department what “overlays” they have to the IRS rules.