Should you tap your retirement account for a down payment on a home?

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Should you tap your retirement account for a down payment on a home?

When you buy a home, putting a down payment toward your purchase can make a big difference.

It may help convince the seller to accept your offer and reduces the amount you need to borrow, lowering the total interest and monthly payments you’ll pay over time. If you’re able to put down 20% or more of the purchase, you may even avoid paying private mortgage insurance.

But you might not have thousands of dollars to put toward your new home, especially if you aren’t currently selling a home in which you hold a lot of equity. You may be tempted to dip into a retirement account or two to help fund your purchase.

But draining your retirement is usually not a great idea. Here’s why you should avoid tapping your retirement account for a down payment on a home.

Early withdrawal penalties

If you’re withdrawing money from your retirement accounts before age 59 ½, you’ll owe taxes on the withdrawals and the IRS will slap you with an early withdrawal penalty. Here’s how you’d be losing money on the deal before you can even buy your home:

  • 401(k): Taking from your 401(k) means you’ll owe taxes on your pre-tax contributions and earnings. Plus, you’ll pay a 10% early withdrawal penalty to the IRS (you can avoid penalties by “borrowing” against your 401(k), but then you’ll need to pay it back through automatic paycheck deductions with interest).

  • Roth IRA: Contributions to a Roth IRA have already been taxed, and so withdrawing contributions is penalty-free. But any earnings you withdraw are subject to tax and the 10% penalty, with one exception: If you’ve had a Roth IRA for five years and you qualify as a first-time homebuyer, you can withdraw up to $10,000 penalty and tax free).

  • Traditional IRA: Any early withdrawals from a traditional IRA are subject to tax and a 10% penalty. Similar to Roth IRAs, first-time homebuyers are also able to withdraw up to $10,000 penalty-free (you’ll avoid the penalty but still owe regular income taxes).

“There's obviously a tax consequence of taking a $10,000 distribution from a pre-tax retirement account,” said Ryan Firth, certified public accountant and president at Mercer Street, a financial and tax services firm. “The individual will owe taxes on that distribution and it will be taxed at her highest marginal tax rate, whereas if it's from a Roth account, there should be no taxes owed.”

If you have to use your retirement savings and you qualify as a first-time homebuyer, you can withdraw from an IRA. To qualify, you cannot have owned a home as your primary residence within the past two years. You can also gift the withdrawal for a down payment to children, grandchildren or parents who qualify as first-time homebuyers. Remember, if you’re buying your home with a spouse or partner, they can also withdraw $10,000 from their own IRA penalty free.

There is no exemption for 401(k)s, so to avoid a penalty you’d need to roll over your 401(k) into an IRA, which you can’t do if you still work for the employer that sponsors the plan. Borrowing against your 401(k) is technically an option, but you’ll have to pay it back with interest.

If you can start taking distributions from your retirement account, you don't need to worry about early withdrawal penalties. But you will need to consider the tax implications and the future value of your retirement account.

Diminished earning potential

Not only will early retirement withdrawals lead to penalties, they’ll diminish future retirement earnings. Withdrawals will no longer be invested and won’t provide earnings in the form of compounded interest.

Even withdrawing your money a few years earlier than planned could significantly reduce the future value of that money. So think hard before your shortchange your future retirement to buy a home.

The “return” on your retirement withdrawal

It’s not a great idea to withdraw from a retirement account to buy a home because there isn’t much opportunity for a “return” on your withdrawal. Homes are often referred to as an investment, but that’s not always the case. A home that gradually increases in value over the years may not make up for the taxes, penalties and diminished earning potential you experience by withdrawing from your retirement account early.

There are often operating costs to own a home, including loan interest, property taxes, homeowners insurance, homeowners association fees, utilities … the list goes on. (You can learn more about the hidden costs of owning a home here.)

“Unless it's used as a rental property, homes are typically not good investments,” said Firth. “Historically, they've marginally outpaced inflation.”

Alternatives to tapping your retirement account

Instead of withdrawing from your retirement account for a down payment, consider these options:

  • Down payment assistance programs: Some states, counties, lenders and even federal agencies offer down payment assistance programs. Assistance may come in the form of a grant, interest-free loan or debt. Keep in mind that there are strict requirements involved (including income, how long you must stay in the home and if you’re a first-time homebuyer) and these programs can stretch out the underwriting process.
  • Friends or family: Friends or family members with disposable income or savings may be willing to make a cash gift (or retirement withdrawal) toward your down payment. (Here’s how to avoid the Bank of Mom and Dad.)
  • Valuables with resale value: Valuables such as jewelry, antiques and other nonessentials can be sold to fund your home purchase. Bonus — you’ll have less stuff to move into your new home. Learn how to monetize your stuff.
  • The waiting game: If the finances really don’t make sense, it may be time to lower your budget or wait and save up for a down payment. In the long run, this will cost you much less than an early withdrawal from your retirement.

“I generally don't recommend that someone takes a distribution from her retirement account to fund the purchase of a primary residence. I see that as a last resort when all other funding options have been considered and ruled out,” said Firth.

Thinking about buying a home? Read our guide.

Image: Breno Assis