Using Retirement Savings for a Home

It is often pretty hard to come up with the money for a down payment on a new house purchase so it’s natural for people to look to what is often their largest savings account: their retirement. But which types of retirement accounts can be used for a down payment, and should you do it?

There are four main types of retirement accounts that we’ll discuss, in order of ease of use: Roth IRA, Traditional IRA, 401k, and Roth 401k. We will not discuss SEP accounts, which are the same rules as an IRA, or TSP accounts, which are similar to a 401k but slightly different. But we’ll throw in taxable investment accounts for good measure.

Roth IRA

The most preferred plan here is a Roth IRA becuase it has already been (mostly) taxed. Because it’s a Roth IRA you can pull out your contributions anytime for any reason with no penalty and no taxes. But make sure you’ve kept good records because there are more rules involved if you want to withdrawl the earnings, or increase in value. As long as your oldest roth account is at least five years old, you can take out up to $10,000 from the earnings for a first time homebuying expense and while you will pay taxes on it, you will not pay a penalty. First time homebuyer means that neither you nor your spouse have owned a home in the last two years. But the good news is that both you and your spouse can take out $10,000 for a total of $20,000. Keep in mind that this is a once per lifetime exemption so plan accordingly. If your oldest account isn’t at least five years old or you need to pull more money out, you can but you will pay a penalty of 10% plus taxes (only on the earnings, of course).

Traditional IRA

A traditional IRA is the next best choice, though it’s much worse than the Roth. You can take out $10,000 for a first time home (same rules as above) with no penalty but you will pay income taxes. This is also a once per lifetime exemption and can also be done for both spouses. If you want to withdrawl more, you just pay a 10% penalty and normal income taxes.

Traditional 401k

The traditional 401k is much more limited than an IRA, partially because it has to follow the plan rules as well as IRS rules. If you are not currently working at the employer your 401k is at, you can cash it out for any reason and pay a 10% penalty as well as income taxes. If this is the case, you should probably consider rolling the old 401k over into a traditional IRA.

If you are still employeed there, you can’t just take out the money from your 401k unless you qualify for a “hardship exemption”. Some plans will not offer it but most will allow for an exemption for a purchase of a primary residence, home repairs in a federal disaster, or to prevent forclosure. You can withdraw whatever you need for the hardship up to the total of your contributions to the 401k (not earnings), but you will pay a 10% penalty and normal income taxes. Also, you can’t contribute to your 401k for the following six months.

Another popular option is to take a 401k loan. You can borrow the lesser of $50,000 and half of the value of the 401k. You typically have five years to pay back the amount but some plans allow longer if the loan is for a house. While this is a nice option, it can increaes your monthly payment drastically and often more than the increased APR and PMI you would pay with a smaller down payment, though you’ll be “paying yourself back” rather than it going to the bank. Another gotcha here is that if you are fired or quit that company, you have six months to repay the loan in full or it will count as an unqualified distribution and you’ll have to pay income tax and a 10% penalty.

Roth 401k

The roth 401k plans have no hardship rules like a traditional 401k so if you still work at the company, you can’t access your money unless you take a loan from your Roth 401k using the same rules that apply to the 401k above.

Taxable Investment

The final type of account is a regular taxable investment account, be it stocks, mutual funds, money market, CDs, etc. This type of account is the least advantagous for tax purposes so it is the most flexible to use. Pull out whatever you want at any time for any reason, but you will pay income tax on the earnings or “capital gains”. If it’s stocks or mutual funds and you’ve held them less than a year, then you’ll pay short term gains tax (whatever your normal federal income tax rate is), and if you’ve held them for more than a year you’ll pay long term gains tax of 0%, 15%, or 25% depending on your tax bracket.

Another thing to think about here is when you are gifted stock. It’s not uncommon for relatives to give a young couple some stock or mutual funds to help with the down payment on their first home. So after you sell them, how do you determine how much was earnings that you have to pay tax on? Earnings are the difference between the selling price and what you paid or “cost basis”. If you bought a share at $10 and sold it at $15, then your cost basis is $10 and your earnings are $5. When you inherit a share, the cost basis becomes the value on the day the person died. But if the person is still alive, the cost basis is whatever their cost basis was. This is unfortunate if it’s a stock from a long time ago that has gone way up in price because it will mean you will have lots of “earnings” that you pay tax on. What happens if you or they don’t know their cost basis? This is very common since banks weren’t required to keep a record of cast basis until 2011. The IRS requires you to do everything you can to get an accurate estimate of what that cost basis is. You can look through old records, try calling the brokerage, etc. You may have to estimate based on what you do know about when it was purchased; if you know it was purchased in 1987, then you can average the price across 1987 and use that as the basis or you can just take the lowest price during 1987. At the end of the day, if you can’t figure it out through any means, you can use the value on the day they gifted it to you. But remember, on the off chance you get audited by the IRS, you will have to sit down and explain how you calculated your cost basis. If they think you took a reasonable approach, then you’re good. If they think you did it incorrectly, you will have to pay the difference in taxes as well as interest. If they think you intentionally lied, then it’s tax fraud and they may prosecute or at least penalize you.

Should you do it?

Well now, here’s the sixty four thousand dollar question. Or ten thousand, or fifty thousand, depending on your case. If you look at all the other websites spelling out this info, you get about 50% info and about 50% yelling at you not to do this because it’s a bad idea. Now, I’m not saying it’s a good idea to use your retirement to buy a house, but I think you can figure that out for yourself. There are lots of times it will make sense and lots of times it won’t and you’ll just have to determine for your situation what is best. By taking money out of your retirement, you’re reducing the future earnings and because of compound interest that could be a big chunk of money in the future. This still applies if you take a loan from your 401k because even though you “pay yourself back” in the meantime that money could be making more money. Of course, the opposite also applies in that the market could have a downturn and that money wouldn’t be making any money for you; you never know.¬† You might be better of paying PMI and having a slightly higher interest rate while keeping your investments earning a high percentage in the market; this can be especially true if you have access to low down payment mortgages (184 loans come to mind here). And on the other side, owning your home can often (not always) be cheaper in the long run than renting because you’re building equity. As I said, every situation is different and you’ll have to decide for yourself. But I tend to think it’s a good option way more often than other people do and is something you should at least consider as part of preparing for a home.

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