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.
Using Your 401K for a Down Payment on a House
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.
Using Your IRA for a Down Payment on a House
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:
- Roth IRA: With a Roth IRA, you can withdraw your contributions to the account at any time, for any reason, without paying the 10% penalty for early (prior to age 59 1/2) withdrawals or paying taxes. This means that you can withdraw money you have contributed for your down payment without being penalized. If you have had your Roth IRA for at least five years, you can take out $10,000 in earnings without tax or penalty — but it has to be for your first house.
- Traditional IRA: With the Traditional IRA, you can withdraw up to $10,000 to use for a down payment on your first home without the 10% early withdrawal penalty. However, you still need to pay income taxes on the amount you withdraw. This is true for SEP and SIMPLE IRAs as well. You do need to use the money within 120 days to purchase your home, though, or you will be hit with the penalty.
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.
Miranda is a professional personal finance journalist. She is a contributor for several personal finance web sites. Her work has been mentioned in and linked to from, USA Today, The Huffington Post, The San Francisco Chronicle, The New York Times, The Wall Street Journal, and other publications. She also has her own personal finance blog: Planting Money Seeds.