Saving for a down payment on a house can be a huge undertaking, but it can pay off in the long run. It’s possible, though, to hurry things up by using retirement account funds. We’ll talk about how to avoid paying fines and taxes when buying your first house, as well as what kinds of accounts aren’t affected by this.
Using Your IRA to Make a Down Payment on a House
The IRS imposes a 10% penalty on early withdrawals from retirement funds if they are made by someone younger than 59 1/2.
When considering your retirement savings options, the withdrawal of funds from a Roth IRA will result in the lowest tax and penalty obligations. This is due to the fact that there is no time limit on making withdrawals and no corresponding tax or penalty for doing so.
In addition, after 5 years, you can take out up to $10,000 tax-free and without penalty to go toward your first home’s acquisition, renovation, or repair. If you take out all of your contributions, you won’t owe taxes or a 10% penalty, but you will have to pay taxes on the whole $10,000 you took out.
However, there is a catch: your withdrawal profits must be spent within 120 days or you risk having to pay a penalty. Furthermore, your financial services company will expeditiously extract all of your contributions from a Roth IRA before any earnings.
Next best is a typical Individual Retirement Account. You can still withdraw up to $10,000 penalty-free from an IRA or 401(k) to put toward your first home’s purchase, repair, or improvement; but, you’ll owe normal income tax on the whole amount. The guidelines for SIMPLE and SEP IRAs are identical.
Similarly, the 10% penalty will be applied if you withdraw money from a conventional IRA and don’t use it to buy a home within 120 days. As an alternative, you can access up to $10,000 tax-free to put toward the down payment on a property for a spouse, parent, or grandparent.
If you and your spouse are married, you may both withdraw $10,000 from your respective conventional IRAs tax-free in order to have a total of $20,000 for a down payment, just like with a Roth IRA. There is a lifetime cap of $10,000 per person.
Making a Down Payment with Your 401k
Any withdrawal from a 401(k) will be considered a “hardship exemption,” even if it’s used to buy a home, because there is no particular penalty exemption for home purchases. The amount you withdraw will be subject to income tax and a 10% early withdrawal penalty.
To avoid the 10% early withdrawal penalty, you should transfer the funds to an IRA if at all possible. A 401(k) with your current company, however, cannot be rolled over. It’s a good idea to roll over any 401(k) funds from a previous workplace. It is recommended to start the rollover paperwork as soon as feasible.
Using Your 401k to Borrow
Borrowing against your 401(k) is another choice. To borrow up to $500,000 or 50% of the account’s worth, whichever is smaller. Providing you can afford the installments (yes, you do have to pay back this loan), this is typically a cheaper alternative to taking the money out of your account all at once.
Even though you will have to pay interest on the borrowed funds, you will not be subject to any additional taxes or fees. Factors to consider before taking out a 401(k) loan:
- Because you will be accruing debt and will be required to make monthly payments on the loan, your ability to get a mortgage may be hampered.
- The interest rate on 401k loans is typically two percentage points higher than the prime rate. The interest you pay, on the other hand, does not go to the firm; instead, it goes into your 401k account.
- Many programs only offer you five years to pay back the debt. In other words, if you borrow a huge sum, your payments may be significant.
- If you quit your job, you may be compelled to repay the unpaid sum within 60 to 90 days, or you may be forced to take a hardship withdrawal. This means you’ll have to pay taxes and penalties on the remaining balance.
- If you have payments taken from your salary, the principal payments are not taxed, but the interest payments are. Because you’ll be taxed again on withdrawals during retirement, the interest payments will be taxed twice.
If you’re receiving an FHA loan and just require a tiny down payment, a loan from your 401(k) may be a good option to offset the cost of the down payment. However, if you have a significant loan payment, it might drastically affect your ability to get a mortgage.
Take into account that the monthly payment (at 6% interest) on a 401(k) loan of $5,000 will be $93, while the monthly payment (at 6% interest) on a loan of $25,000 would be $483. The latter payment may significantly impact your capacity to make the monthly mortgage payment, thus the bank will take this into account when determining your loan amount.
As a result, before you take out such a loan, you should do the math and inquire with your mortgage broker as to how it would affect your qualifying. On the other hand, if withdrawing the down payment amount and paying the taxes and penalties would have too negative of an impact on your qualifying, it may make sense to do so.
Mortgage Interest Tax Planning
After buying a property, you can deduct the interest you pay on your mortgage from your taxable income. You can “wash” part or all of this with retirement account withdrawal income.
Imagine you have a $25,000 mortgage interest payment and a $25,000 401(k) withdrawal in the same year. Withdrawing $25,000 from your 401(k) will result in a $25,000 increase in income, which will be offset by the $25,000 deduction for mortgage interest.
Simply said, the withdrawal won’t raise your taxable income, thus you won’t owe any additional tax as a result of it. However, the 10% penalty, or $2,500 in this situation, will still be your responsibility. Withdrawals from a traditional IRA, SIMPLE IRA, or SEP can also be made using this method; however, the 10% penalty will apply if the amount withdrawn is greater than $10,000.
Comparison of Retirement Account Withdrawals
Which is best then? The answer to this question is contingent on the types of accounts you maintain and the amounts you’ve put into them. Withdrawing funds for a down payment from a Roth IRA rather than a standard IRA, and then from either of those accounts rather than a 401(k), will result in lower taxes and penalties.
Whether or not a 401(k) loan is preferable to an IRA withdrawal is determined by the size of the loan and how it can affect your eligibility for the mortgage you’re seeking.
- Contributions to a Roth IRA are exempt from both income tax and the 10% penalty.
- Earnings in Your Roth IRA up to $10,000 for the Purchase of a First Home: No income tax is owed and no 10% penalty is incurred.
- Small 401k Loan: No income tax or penalty is due. The monthly payments will be modest and will have a negligible impact on mortgage eligibility.
- Any Withdrawal Up to $10,000 From a Traditional IRA, SEP-IRA, or SIMPLE IRA for the Purchase of a First Home: No Income Tax Due, No 10% Penalty
- Profits inside Your Roth IRA Over $10,000 for the Purchase of a First Home: You will owe income tax and a 10% penalty.
- Any Withdrawal Over $10,000 From a Traditional IRA, SEP-IRA, or SIMPLE IRA: Income tax is required and a 10% penalty is owed.
- Large 401k Loan (Limited to Half of Balance or $50,000, Whichever Is Smaller): No tax or penalty is due. Monthly payments can be hefty and significantly impact mortgage eligibility.
- Any 401k withdrawal will incur income tax and a 10% penalty.
When I bought our house with money from my IRA, I was relieved when the market crashed shortly thereafter. It might take a considerable amount of time to save enough for a down payment.
You may start saving on rent and taking advantage of tax deductions for mortgage interest as soon as you purchase a property. As an added bonus, you may access up to $10,000 from these funds tax-free to make necessary repairs or renovations to your first property.