Laura reviews the rules for using your workplace retirement plan or individual retirement account (IRA) to buy a home, and if it’s a good idea.
Laura reviews the rules for using your workplace retirement plan or individual retirement account (IRA) to buy a home, and if it’s a good idea.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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If you're a homeowner, you're probably thrilled that home prices in many parts of the country are at all-time highs. When your home value increases, so does your equity and net worth.
But what if you need to buy a home? Not only are prices sky-high, but mortgage interest rates and home insurance premiums can put homeownership out of reach for many Americans.
If you have existing home equity, you can use it to purchase your next home. However, suppose you have little or no equity or aren't a homeowner. In that case, you must have plenty of savings to cover various closing costs, including a downpayment, mortgage underwriting fees, appraisal, survey, title insurance, transfer fees, recording fees, and more.
If cash is tight, you may wonder if you can use your retirement account to cover some of the closing costs. This post will review the rules for using your workplace retirement plan or individual retirement account (IRA) to buy a home.
Hey friends, welcome back! I'm Laura Adams, an award-winning author, money speaker, founder of The Money Stack newsletter, and host of the Money Girl podcast with 43 million downloads. I also work as an on-camera financial spokesperson and partner with select brands for PR and content marketing. As always, you can learn more and email me at LauraDAdams.com.
If you have a comment or money question, please leave it on our voicemail at 302-364-0308. I'd love to answer your question on a future show!
How to use a 401(k) to buy a home
If you're a Money Girl listener, you probably know that a traditional 401(k) or 403(b) are tax-advantaged, employer-sponsored accounts that help you save for retirement and reduce your taxable income. You make pre-tax contributions and then pay income taxes when you make withdrawals in retirement.
Because retirement accounts come with such great tax benefits, there are many rules you must follow to avoid taxes and penalties. For example, when you withdraw funds before age 59.5 (or 55 if you retire early) that weren't previously taxed, you must pay income taxes plus an additional 10% early withdrawal penalty.
In addition, most workplace retirement plans only allow you to tap funds if you have a documented hardship approved by the IRS. They include paying funeral expenses, medical bills, education costs, and buying a primary residence.
However, you still must pay taxes and a 10% penalty on hardship distributions, which means a big tax bill! In addition, taking a hardship withdrawal means you can't make new contributions to your retirement account for six months.
However, two exceptions allow you to withdraw money from a workplace retirement plan to buy a home and avoid taxes and penalties.
RELATED: How to use a mega backdoor Roth conversion
Should you take a 401(k) loan to buy a home?
A 401(k) loan allows you to withdraw a portion of your retirement funds and repay it with an interest rate specified in your plan. Paying interest is to make up for lost growth while your "loaned" funds are not invested.
If a retirement loan is allowed, you can only borrow half your vested balance, up to $50,000. For example, if you have an account balance of $60,000, the maximum you can borrow is $30,000. If your balance is $200,000, the most you can loan yourself is $50,000. You can even have multiple loans as long as you don't exceed the total.
Retirement loans typically have a repayment period of five years, but it could be longer if you use one to buy a home. You must make payments in equal amounts that include principal and interest, which get deducted from your paycheck.
If you repay a 401(k) or 403(b) loan on time, you don't pay income tax or a penalty.
However, one of the biggest problems with taking a loan from your workplace retirement account is that the outstanding balance is considered an early withdrawal if you miss a payment deadline. In other words, you'd have to pay income taxes plus the 10% penalty on the entire unpaid loan amount.
Additionally, if you leave your job or get fired, any outstanding loan balance is treated as an early withdrawal unless you repay it by the due date of your federal tax return.
RELATED: What should I do with an old 401(k)?
Advantages of taking a 401(k) loan to buy a home
If you believe a retirement plan loan is right for you, here are four primary benefits.
1. You receive funds quickly.
Since there isn't a lender, you don't need to apply, submit income documentation, or pay an underwriting fee. You complete a loan document with the firm that manages your retirement plan, and your funds are usually available within a week.
2. You pay a low interest rate.
The interest rate is typically lower than for other types of debt, and it goes back into your retirement account. Depending on what happens in the markets, repaying a retirement loan could leave you with more or less in the account.
3. You don’t need a credit check.
Since you are your own lender, your credit isn't a factor.
4. You can spend it any way you want.
When you take a 401(k) loan, how you spend it is entirely up to you. However, as I previously mentioned, a loan to purchase a home may qualify you for a longer repayment term. So, be sure to let your account custodian know if you use any portion of a retirement loan to buy, build, or remodel a home.
LISTEN ALSO: 5 steps to achieve FIRE (financial independence retire early)
Disadvantages of taking a 401(k) loan to buy a home
Here are four disadvantages to consider.
1. You miss potential market gains.
The purpose of having a retirement account is to allow your money to grow for the future. Funds you withdraw may miss significant potential investment growth. Even if you repay a loan on time, you could come up short, depending on what happens in the markets.
2. Your interest paid is non-deductible.
The interest you pay on a retirement loan isn't tax-deductible. Therefore, if you plan to use it to buy a home or pay for education, you'd be better off getting a mortgage or a student loan. Those loans allow you to deduct some of your interest from your taxable income.
3. You could have an expensive penalty.
If you take a 401(k) loan and something unforeseen happens, such as having a financial hardship or losing your job, you could end up in a tight spot. Separating from your employer for any reason means that your entire loan balance is due by the tax filing deadline.
As I mentioned, if you can't repay a retirement loan, it's considered an early withdrawal, subject to taxes and a 10% penalty if you're younger than 59.5. So, ensure all is well with your job before you take a retirement account loan.
4. You can't make new contributions.
Even though loan payments go back to your retirement account through payroll deductions, they don't count as contributions. That means you'll miss out on any employer matching. Your plan may also specify that you can only contribute once your loan is fully repaid.
I recommend borrowing from your workplace retirement plan or withdrawing Roth contributions as a last resort. Consider other options, such as getting a mortgage, home equity loan, student loan, or using money in your IRA, which we'll cover next.
READ ALSO: How should I invest for retirement after a 401(k)?
How to use an IRA to buy a home
Since you have more control over funds in a traditional or Roth IRA, it may be a better account to tap than a workplace retirement plan when needed. There is a special IRA provision for first-time homebuyers or anyone who has not owned a primary residence in the last two years.
It allows you to withdraw up to $10,000 from a traditional IRA for a home and skip the 10% penalty, even if you're under 59.5. But you will have to pay income taxes on that amount.
If you have a Roth IRA, you can withdraw as much of your original contributions as you like at any time and for any reason with no taxes or penalties. However, early withdrawals of Roth earnings would be subject to taxes. But you could use up to $10,000 of earnings to buy a home and avoid the 10% penalty if you're under 59.5.
Should you tap a retirement account to buy a home?
To sum up, you can use a retirement account to buy a home. However, if you're younger than 59.5, withdrawing from a traditional 401(k) or 403(b) means paying taxes plus a 10% penalty, which is expensive!
If you're a first-time homebuyer or haven't owned a home in the past two years, you can withdraw up to $10,000 from a traditional IRA. As I mentioned, you'll pay taxes but skip the 10% early withdrawal penalty. If you're a couple and each has an IRA, you could withdraw $20,000 penalty-free to buy a home. However, your taxable income will increase by the amount you withdraw.
If you have a Roth at work or a Roth IRA, that's the least expensive and most flexible way to withdraw funds for a home. Again, you can always withdraw your original contributions tax and penalty-free.
The home buying strategy that's right for you depends on your retirement savings and how much you need to buy a home. Taking a retirement withdrawal could be a good move if your desired property appreciates significantly or if becoming a homeowner saves you money over the long term compared to renting.
However, taking too much from your retirement account for a home could make it challenging to reach your savings goal or cause you to delay retirement and work longer than you planned. So, speak with a financial advisor about the pros and cons of tapping your retirement account to buy a home.
READ ALSO: How to know if you can retire early
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