Episode 301: February 5, 2013
by Laura Adams
If you want to buy a home, but don’t have enough saved for a down payment, you might wonder if it’s possible to tap your retirement fund for this special occasion.
There are certain situations where using a retirement account to buy a home is allowed. We’ll cover the rules—and whether using retirement savings for a down payment is a good idea.
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Tapping a 401(k) to Buy a Home
Retirement plans that you can only get through an employer, such as a 401(k) or 403(b), are the most popular types of retirement accounts. If you have one, there are 2 ways to tap it: taking a loan or making a withdrawal.
Taking a loan from a workplace retirement account is always the best option because you’re obligated to repay yourself with interest over a set period of time. When you take a withdrawal, on the other hand, you’re actually not allowed to repay it except by bumping up the amount you contribute from each paycheck.
Taking a Loan from a 401(k)
But not all workplace retirement accounts are set up to allow loans. If they are allowed, there’s a limit to the amount you can get: You can only borrow half of your vested balance, up to $50,000.
Vested funds are those that you own, and you’re always 100% vested in the contributions you make. However, in some cases money from your employer—such as matching or profit-sharing funds—may be tied to a vesting schedule that gives you ownership over time.
Retirement account loans come with a set interest rate and term spelled out in the plan document. The repayment period is typically 5 years, but may be longer for a home purchase. If you repay a loan on time you don’t have to pay income tax or a penalty on the borrowed funds.
However, one of the biggest problems with taking a loan from your 401(k) or 403(b) is that if you don’t repay it on time, the outstanding balance is generally considered an early withdrawal, subject to income tax plus an additional 10% penalty, if you’re younger than age 59½.
If you leave your job or get fired, you’ll probably have to come up with the entire outstanding loan amount within a short period of time, such as 60 days. So be sure to read your retirement plan document or ask your benefits administrator for all the details on taking a loan before signing up.
Taking a Withdrawal from a 401(k)
If your 401(k) or 403(b) doesn’t allow loans, or you need more than the allowable loan amount, you may be eligible to take a “hardship” withdrawal, if permitted by your plan. Certain qualifying events, such as buying, repairing, or preventing foreclosure on a primary home, fall under the hardship category.
But the bad news is that a hardship withdrawal always comes with income taxes and a 10% early withdrawal penalty (if you’re younger than age 59½). Plus, you’re typically restricted from making contributions to your retirement account for 6 months.
Therefore, my recommendation is to never take a hardship withdrawal from a workplace plan. You’ll pay hefty taxes, miss out on contributions and potential employer matching funds, and be left with a depleted retirement account.
Taking a Withdrawal from a Traditional IRA
Another type of retirement account that’s available to just about everyone is the Individual Retirement Arrangement or IRA. You contribute to a traditional IRA on a pre-tax basis and to a Roth IRA on a post-tax basis. With either type of IRA, loans are not permitted, but you can take a withdrawal in certain cases.
For a traditional IRA you’re allowed to withdraw up to $10,000 for a down payment only if you’re a first-time homebuyer. You must pay taxes on the withdrawal—but even if you’re younger than 59½ you won’t get hit with the 10% early withdrawal penalty.
Taking a Withdrawal from a Roth IRA
The rules for taking a withdrawal from a Roth IRA to buy a home are much more favorable than for a traditional IRA.
Since you make contributions to a Roth on an after-tax basis, you can withdraw them for any reason without owing taxes or a penalty, no matter your age. However, if you tap the growth or earnings on your original contributions, taxes and an early withdrawal penalty will apply.
So, if you need to tap a retirement account to buy a home, taking a modest withdrawal from your Roth IRA is the best possible option. However, Roth IRAs are capped so those with higher incomes can’t make contributions.
Owning a home of your own can be a very smart investment, especially with today’s low market prices and interest rates. Just make sure you tap any type of retirement fund with caution because depleting it means you’re giving up the opportunity to build wealth. It’s a good idea to consult with a financial adviser so you carefully weigh the pros and cons of such an important decision.
While taking a loan or withdrawal from a retirement account may make sense for some home buyers, the best scenario is to have plenty of savings so you don’t need to touch your retirement nest egg in the first place.
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