Even after the crash of the housing market, homeownership remains a major financial milestone for many. Indeed, for some, homeownership is still a major part of the American Dream. If you’re going to buy a home, though, you will likely need a down payment — especially if you want the best mortgage rate. For those trying to make a 10% or 20% down payment on home, though, coming up with tens of thousands of dollars in capital can be a challenge.
In order to get the money, some turn to their tax-advantaged retirement accounts. While your retirement account can be a source of the funds needed for a down payment, though, you do need to be careful. It’s not always the best idea to raid your retirement account to buy a home.
The 401k is still a very common retirement account. You can withdraw money from your 401k, but you need to be prepared to pay a 10% penalty if you are under age 59 1/2, and you will need to pay income taxes on the amount that you withdraw. This will significantly reduce the amount of money that you can put toward your down payment.
In order to avoid the penalty, you can try to roll your 401k to an IRA so that you can take advantage of the home buying exemption that first-time buyers get when they withdraw from an IRA (more on that below). However, realize that you can’t roll the 401k over if you are still working for the employer that offers the plan. Make sure you perform the rollover from an account set up with a former employer.
Another way to avoid the penalty is to borrow from the 401k, rather than withdraw the money outright. Generally, you will need to be able to repay the 401k loan back (with interest — but it’s interest paid to yourself) within five years. Also, realize that the amount you can borrow for your home might be impacted, since a 401k loan is, in fact, debt.
There is also the possibility that your interest paid on the 401k loan will be double-taxed. If you have loan payments deducted from your paycheck, the principal won’t be taxed, but the interest will be taken out post-tax. Since you’ll be taxed on withdrawals later in retirement, the interest is taxed again when you take distributions. Finally, make sure that you understand that if you leave your job for any reason, you may need to pay back the loan within 60 to 90 days or it will be treated as a withdrawal.
One of the many advantages associated with the IRA is that there is a penalty exemption when you use money withdrawn to help with the purchase of your first home. The rules are different, depending on whether you have a Roth IRA or a Traditional IRA:
With the IRA, you and your partner can each withdraw up to $10,000 for the down payment, bringing your total to $20,000. And, of course, depending on how much you’ve each contributed to your Roth accounts, the amount you can withdraw combined is virtually unlimited.
While you can get help with a down payment on a house from your retirement account, it’s a good idea to think twice. There are limitations to what you can do, and you might be subject to penalties. Plus, you can’t replace the opportunity cost that comes with having that capital absent from your account, and unable to earn compound interest.
Photo credit: highlandhomes.
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