It goes without saying that your retirement funds are usually best saved for your retirement. However, sometimes it may be beneficial to utilize your retirement funds for the purchase of a home. With interest rates at record lows, home prices on the rise and homeownership offering many potential advantages, you may want to tap retirement funds to make your home purchase happen. Here’s how you can use these funds toward your down payment or closing costs when buying a home.
Retirement funds defined
For the purposes discussed here, retirement funds are those contained in designated retirement accounts such as 401(k)s, Traditional IRAs and Roth IRAs. 401(k)s are tied to employment, and participants have full ownership of their contributions (known as being “vested”), but participants may not be immediately vested in employer contributions until after a certain period of employment. IRAs are arranged independent of any employer. Contributions to 401(k)s and IRAs are both limited by annual caps.
In part because these accounts provide special tax advantages, they are subject to specific rules regarding when and how their funds can be withdrawn. There are three typical ways to use retirement funds for home down payments or closing costs:
- Borrowing from retirement funds
- Withdrawing from retirement funds
- Diverting upcoming retirement contributions
Borrowing from a 401(k)
If you have a 401(k) account, you can borrow up to $50,000 or half of your vested balance, whichever is less. You’ll then need to pay back the borrowed amount with interest. While this creates an additional debt to pay, it can be a good tax-free source of additional cash for a down payment.
Many 401(k)s require the loan to be paid back within five years. If you leave your job, the entire loan may come due immediately. If you can’t pay back the loan within the deadline, it will become an early withdrawal, subjecting you to a 10 percent penalty and income tax payments.
Despite being called a “loan”, there is no lender and typically no credit impact involved in borrowing from your 401(k). The loan principal and interest are paid back to yourself, although your 401(k) may assess some fees in the process. Borrowing may be considered the most preferable way to access retirement funds because it provides a way to fully return the funds to your account without being subject to contribution caps.
Using funds from IRAs
With a traditional IRA, you can withdraw funds at any time for any purpose with no need for repayment. However, your withdrawals will be subject to regular income tax, and if you are withdrawing before age 59½, a 10 percent early withdrawal penalty will typically apply.
A Roth IRA offers more flexibility since your contributions (not the investment earnings) can be withdrawn at any time for any purpose without tax, penalty or need for repayment. If the earnings are withdrawn before age 59½, they may be subject to income taxes and a 10 percent penalty.
If you’re a first-time homebuyer, you’re allowed to use up to $10,000 from a traditional or Roth IRA to buy, build, or rebuild a home without paying the 10 percent early withdrawal penalty. Traditional IRA funds used in this way are still subject to income taxes, but Roth IRA funds (even if they are earnings) are tax-free if it’s been at least five years since the account was opened. Generally, you’re considered a first-time homebuyer if you haven’t owned or had a financial interest in a home during the past two years.
You can also access the funds from a traditional or Roth IRA for 60 days without tax or penalty in what’s known as a tax-free rollover. This is allowed once per year (regardless of how many IRAs you have) and requires that you return the funds to an IRA within 60 days. Accessing IRA funds in this way can be useful for bridging the purchase of a new home before selling a current home. If the funds aren’t returned before the 60-day deadline, taxes and penalties will apply.
Diverting upcoming retirement contributions
You can also simply reduce or eliminate some of your ongoing retirement contributions to use the funds toward a down payment. This means you may miss out on future tax-advantaged returns, of course. If you’re employer offers matching contributions to your 401(k), you may wish to continue contributing enough to earn some or all the match, which is generally considered “free money”. Since the funds you withhold will have never been in a retirement account, you’ll have far greater flexibility in how you can use them.
Utilizing retirement funds to achieve your homeownership goals can be a worthwhile strategy, but it shouldn’’t be undertaken lightly, either. Consult both your lender and your financial adviser for complete advice and the current requirements. While having sufficient cash on hand is the smoothest way to pursue a home purchase, we’re always available to help you explore all the options to help make your home purchase possible. Contact us if you’d like a free mortgage consultation.