If you've been socking money away in a retirement account and are ready to buy a home, you could tap into that savings to boost your buying power. There are several ways to use retirement funds to put a down payment on a home.
Here are the basic options to tap into retirement savings to purchase your first home:
401(k) loan. If you withdraw funds from a 401(k) to buy your home you will trigger steep penalties and taxes. A more economical option is to borrow from your 401(k) to buy a home. You can borrow up to the lesser of $50,000 or half of your vested account balance. You don't have to pay taxes on the money, but you do have to repay the loan on time. The timing for repaying the loan varies, but keep in mind that if you leave your current employer, you may have to pay back the funds upon severance to avoid penalties.
Traditional IRA. You can withdraw up to $10,000 form a traditional IRA to buy a home for the first time without paying a tax penalty, though you will have to pay income tax on the amount withdrawn. If both spouses tap into their individual accounts, you can double this amount.
Roth IRA. If you have money in a Roth IRA, you can withdraw contributions at any time, since it's after-tax money. However, if you withdraw investment earnings within five years of opening your account or before age 59 1/2, you may have to pay penalties on those earnings. As with a traditional IRA, you can use up to $10,000 for a first-time home purchase without triggering penalties. However, you may have to pay income tax on any portion of the withdrawal that comes from investment earnings.
These are the ways that you can withdraw from your retirement savings to put a down payment on a house. But just because you can use your retirement account to pay for a first home doesn't necessarily mean you should. Here are some of the pros and cons of using this strategy to buy your first home:
1. You could pay interest to yourself. With a 401(k) loan, the administrators are required to set a reasonable interest rate. But you pay that interest to yourself. The 401(k) loan interest payments are meant to help make up for some of the value you'll lose by taking money out of your 401(k) for a few years.
2. You may avoid paying PMI. Even after the housing crash of 2008, you can still get a low down payment mortgage. But if you put less than 20 percent down on your new home, you'll likely get stuck with private mortgage insurance. This can be hard to get rid of, and can add hundreds to your monthly mortgage payments. Bulking up your down payment with some retirement savings could help you avoid costly PMI.
3. A house can be a good investment. Something to remember when considering whether to use retirement money for a down payment is that you're really pitting one investment against another. Are you likely to get more long-term value from your retirement accounts or out of homeownership. This will depend on a variety of factors, including real estate in your area, rental prices and how long you plan to stay in your home. A home can be a great investment that might make this strategy worthwhile.
1. You reduce the earning potential of your retirement accounts. The real power of tax-deferred retirement accounts isn't in the money you put into them. That's just the fuel that gets them going. Their real power is in compounding interest. The more money that is in your 401(k) or IRA, the more it's earning. Taking that money out of your account, even for a few years, can seriously reduce your account's earning potential.
2. It may be difficult to catch back up on retirement savings. Since you're reducing your account's overall earning potential, you'll have to invest more in your retirement accounts later to catch back up. And if you're taking on a mortgage payment, that can be difficult to do.
Borrowing from a retirement account to put a down payment on a home could help you to become a homeowner sooner. But this strategy will only work out in your favor if your home is truly a good, long-term investment and you can re-fund your retirement account as soon as possible. Carefully run the numbers before making this potentially risky move.