For many people saving for a rainy day is hard enough as it is. Add on top of that all the other financial objectives a person is typically concerned with (i.e. retirement, college savings, paying down debt) saving for a down payment on a home can be difficult. Because of this I often have clients who are interested in accessing funds in their retirement accounts to come up with money for a down payment. In order to do this it’s important that homebuyers be educated on their options. Therefore, I have put together this post to summarize the important points of using 401K, IRA, and Roth IRA funds towards the purchase of a home.
One quick note that is generally applicable to all three sources. Typically funds derived from a retirement plan used towards the purchase of a home may only be used as a down payment and “usual or reasonable settlement costs” and may not be used to pay other debts in order to qualify for a new mortgage.
Rules for each 401K plan are slightly different so homebuyers need to talk with their plan administrators to make sure they can use their 401K. Technically, a person cannot generally withdraw money from their 401K to use towards the purchase of a home. Instead most 401K plans will allow participants to borrow money from their 401K and pay it back with payroll deductions. For funds being used to purchase a home the repayment period can be longer than the normal required period of 5 years but check with the plan administrator to make sure the payments won’t be onerous .
The plan will usually assign an interest rate to the loan but because the participant is paying and receiving the interest the effective cost of borrowing is 0%. However, while the loan is outstanding keep in mind that it is not receiving investment returns so the true cost of tapping into a 401K is the “opportunity cost”. Homebuyers wishing to use their 401Ks should consider the impact this will have on their future ability to retire. Also, keep in mind that repayment of a 401K loan is made with after-tax dollars. Therefore, when that homeowner retires int he future they will effectively pay tax on the loan amount twice (once when they repaid the loan with after-tax dollars and again in retirement when they take a taxable distribution from the account).
Typically the maximum a person can borrow from their 401K is the lesser of $50,000 or 50% of their vested balance. If the vested balance is less than $20,000 then sometimes they can borrow up to the vested balance or $10,000 whichever is greater.
It’s important to note that a person does not have to be a first-time homebuyer to use 401K funds. It’s also important to note that because the homebuyer will pay back the 401K loan with payroll deductions then it is generally not possible to access funds in a 401K with a previous employer. The homebuyer must currently be working for the plan sponsor. This also creates a significant risk because if the employee is terminated during the repayment period on the loan and cannot pay back the remaining balance the amount will be treated as a non-qualified distribution and be subject to ordinary income tax plus a 10% penalty.
Please note that some 401K plans do allow “hardship” withdrawals for participants who qualify as a first-time homebuyer. However, these distributions are taxable so unless cash-flow is a major concern often times a loan will make more sense.
IRAs are different from 401Ks in that a person is able to take distributions instead of having to take out a loan. The question then becomes whether or not the distribution will be a deemed a “qualified” or “non-qualified” distribution. A “qualified” distribution IS NOT subject to a 10% penalty while a “non-qualified distribution” is subject to a 10% penalty.
In order for a distribution to be qualified the homebuyer must be a first-time homebuyer which the IRS defines as a person who has not owned real estate in the previous 24 months. The $10,000 cap is a lifetime limit so once a person has utilized the $10,000 they may not use it again.
So long as the contributions to the IRA were tax deductible for the homebuyer then the distribution will be taxed as ordinary income. If the distribution does not meet the criteria of being a “qualified” distribution then it will also be subject to a 10% penalty. Since the homebuyer will typically incur income tax liability for an IRA distribution it’s important they account for that when budgeting out their money from the time of distribution to the following April 15th when taxes are due.
The rules for Roth IRA distributions used towards the purchase of a home are similar to the aforementioned traditional IRA guidelines in that it is only available for those who meet the IRS’s definition of a first-time homebuyer and is only available up to $10,000. However, there are a couple key differences.
One key difference is that for a distribution to be “qualified” it may not be made inside a 5-taxable-year period which begins January 1st of the taxable year for which the very first contribution was made to any Roth IRA the homebuyer owns. In other words, for a first-time homebuyer who wishes to take a “qualified” distribution from their Roth IRA account anytime in 2010 must have made their very first Roth IRA contribution (to any Roth account) no later than the 2005 tax year.
The other key difference is taxation. Because Roth IRA contributions are not tax deductible at the time of contribution “qualified” distributions are not treated as taxable income. However, if the distribution is not deemed to be “qualified” then it will be subject to a 10% penalty and depending on the contributions made and distribution taken may also have income tax implications.
I hope this summary enables homebuyers out there to make better decisions with their money. Please remember that I am not a tax professional and tax code is subject to change. It is best to discuss your options with a knowledgeable professional when you are close to make such a decision. It is also important to consider the impact that the decision will have on your ability meet your retirement accumulation goals.