As we work our way up the credit stupidity list, in terms of coming up with down payments for houses, we’ve repeatedly told you that borrowing from or against your retirement accounts is stupid. This is why it is number 4 on the list of stupid credit decisions. But it is a step above trying to come up with a downpayment using incredibly dumb credit card tactics I am starting to see people do.
For that reason and that reason alone we are going to discuss what the least stupid way is to take a downpayment on a house from a retirement account – specifically.
First, some definitions:
- Contributions– what you individually set aside from each paycheck of your own money (including employer match) to invest in your retirement account.
- Earnings– the amount of money that your contributions earned in compound rates of return from your investments in the market over time.
General thing to note: The IRS even discourages you from withdrawing money from your retirement accounts early by charging a 10% penalty on withdrawals before you turn 59 1/2.
Among the various kinds of retirement accounts, pulling money from a Roth IRA will cost you the least in taxes and penalties. This is because you can withdraw contributions at any time without penalty or tax. In addition, after you’ve held the account for five years, you can withdraw up to $10,000 in earnings without penalty or tax for the purchase, repair, or remodel of a first home. In other words, if you withdraw all of your contributions, you can still withdraw another $10,000 and not pay the 10% penalty or taxes on any of it.
There is one caveat however: you only have 120 days to spend withdrawn earnings or you may be liable for paying the penalty. Also, for your convenience, your financial services firm will automatically prioritize the withdrawal of all of your contributions from a Roth IRA before any earnings.
The next best choice is a traditional IRA. You’re still able to withdraw up to $10,000 for the purchase, repair, or remodel of a first home without paying a penalty, but you’ll have to pay regular income tax on the entire amount. SIMPLE and SEP IRAs follow the same rules.
With a traditional IRA, you must also use the money within 120 days for the purchase of a home or you’ll get hit with the 10% penalty. Alternatively, you can withdraw up to $10,000 penalty-free for the purchase of a home for your spouse, parents, children, or grandchildren.
Just like with a Roth IRA, your spouse can also withdraw $10,000 from his or her traditional IRA, so you can collectively obtain $20,000 penalty-free for a down payment if you’re married. The $10,000 limit is a lifetime limit for each individual.
Using Your 401k for a Down Payment
There’s no specific penalty exemption for home purchases when you pull money out of a 401k, so any money you take out will be classified as a “hardship exemption.” You’ll be assessed a penalty of 10% on the amount withdrawn and you’ll have to pay income tax on it as well.
If possible, roll over the amount you want to withdraw to an IRA, so you can avoid paying the penalty. However, you can’t roll over a 401k that’s with an employer for whom you are still working. If you have an old 401k from a former employer, roll that. Since a rollover can take time to process, fill out the necessary paperwork as soon as possible.
Borrowing from Your 401k
Another option with a 401k is to take out a loan. Your loan can be up to $50,000 or half the value of the account, whichever is less. As long as you can handle the payments (yes, you have to pay back this loan), this is usually a less expensive option than a straight withdrawal. Though you will pay interest, you won’t pay taxes or penalties on the loan amount.
A few things to know about 401k loans:
- Since you’re incurring debt and will need to make monthly payments on the loan, your ability to get a mortgage may be affected.
- The interest rate on 401k loans is generally about two points above the prime rate. The interest you pay, however, isn’t paid to the company – it goes into your 401k account.
- Many plans give you only five years to repay the loan. In other words, if you borrow a large amount, the payments could be substantial.
- If and basically WHEN you leave your company, you will be required to pay back the outstanding balance within 60 to 90 days or be forced to take it as a hardship withdrawal. This means you’ll be hit with taxes AND penalties on the amount you still owe.
- If payments are deducted from your paycheck, the principal payments will not be taxed but the interest payments will. Since you’ll be taxed again on withdrawals during retirement, the interest payments will end up being double-taxed.
Remember, a large new loan payment could have a big effect on your mortgage qualification.
Consider that a $5,000 401k loan will have a payment of $93 per month (at a 6% interest rate) over five years, while a $25,000 loan will have a payment of $483 per month. The latter payment could seriously hinder your ability to pay the mortgage every month, and the bank will take this into consideration when figuring what you qualify for.
Therefore, you need to run numbers and ask your mortgage broker how such a loan will affect your qualification before you take one out. Conversely, if the amount you need will have too adverse an affect on your qualification, it might make sense to withdraw the down payment amount and pay the taxes and penalties.
Mortgage Interest Tax Strategy
Keep in mind that you’ll be deducting mortgage interest on your taxes after you purchase your home. This may actually “wash” with some or all of the income you report from a retirement account withdrawal.
For example, let’s say you withdrew $25,000 from your 401k and paid $25,000 in mortgage interest the same year. The $25,000 you’ll report in additional income (from the 401k withdrawal) will “wash” with the $25,000 mortgage interest deduction. In other words, your taxable income won’t be increased by the withdrawal, and you will effectively pay no tax on it.
However, you will still be liable for the 10% penalty, which is $2,500 in this case. This type of strategy can work for IRA, SIMPLE, and SEP withdrawals as well, but you won’t be liable for the 10% penalty unless you withdraw more than $10,000.
Retirement Account Withdrawal Comparison Summary
So which is the least stupid? This depends on what accounts you have and how much you have contributed to them. But in general, you’ll be assessed fewer taxes and penalties if you withdraw money for your down payment from a Roth before a traditional IRA, and from either of those before a 401k. Whether a 401k loan is better than an IRA withdrawal depends on how large it is and whether it will affect your ability to qualify for the amount and type of mortgage you’re after.
- Contributions in your Roth IRA: No income tax due, will not owe 10% penalty.
- Earnings in your Roth IRA up to $10,000 for the purchase of a first home: No income tax due, will not owe 10% penalty.
- Small 401k loan: Will not owe income tax or penalty. Monthly payments will be small and will have a minimal affect on mortgage qualification.
- Any withdrawal from a traditional IRA, SEP-IRA, or SIMPLE IRA up to $10,000 for the purchase of a first home: Income tax due, will not owe 10% penalty
- Earnings in your Roth IRA over $10,000 for the purchase of a first home: Income tax due, will owe 10% penalty.
- Any withdrawal from a traditional IRA, SEP-IRA, or SIMPLE IRA over $10,000: Income tax due, will owe 10% penalty
- Large 401k loan (limited to half of balance or $50,000, whichever is smaller): Will not owe income tax or penalty. Monthly payments can be large and substantially affect mortgage qualification.
- 401k withdrawal of any amount: Will owe income tax and 10% penalty.
Now you know.