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When you're trying to buy your first home, coming up with the down payment can be challenging. If you've been saving money for retirement through an IRA or 401(k), you might be inclined to use these funds to afford your house. Here's an overview of what to consider before using your IRA as a first-time homebuyer.
What's the Difference Between Loans & Withdrawals?
There are two ways to take money out of a retirement plan: loans and withdrawals. Some plans offer loans, and if you go this route, the money will have to be paid back.
Loans
As long as the repayment plan is followed, you will not owe taxes or early withdrawal penalties because the IRS doesn't view a loan as a permanent withdrawal. Your retirement plan may charge interest on your outstanding loan, so you might have to pay yourself back more than you originally borrowed.
Withdrawal
When you make a withdrawal, the IRS may tax what you take out, depending on the type of IRA or 401(k) you have.
- For a traditional IRA, every dollar you take out is taxed.
- For a Roth IRA, you can withdraw your contributions tax-free but will still owe taxes for taking out your investment gains early.
If you're younger than 59 1/2, the IRS could also charge a 10% early withdrawal penalty on whatever you take out. However, there are situations where you can avoid the penalty, and buying your first house may be one of them.
Can I Borrow From My IRA or 401(k)?
Unfortunately, there is no such thing as an IRA loan. The only way to take money out of an IRA is through a withdrawal. If you are buying your first house, you can take up to $10,000 out of your IRA to make your down payment without owing an early withdrawal penalty. You'll still owe income tax on the amount you take out, but at least you could avoid the extra 10% penalty.
You may be able to borrow from a 401(k) , but it depends on your employer. Some companies allow 401(k) loans while others do not. If your plan does allow loans, you can borrow either the greater of $10,000 or 50% of your vested account balance, or $50,000, whichever is less, according to the IRS.
After you borrow, you generally have five years to pay back your 401(k) loan with interest and will not owe taxes for borrowing from your 401(k).
Another option is to make a 401(k) withdrawal. The IRS allows plans to offer hardship withdrawals for the purchase of your principal residence, including buying your first home. However, you will be charged income tax and possibly a 10% early withdrawal penalty when you take money out of a 401(k) this way. The IRS does not waive the penalty like it does for an IRA.
Considerations Before Taking a Withdrawal
There can be downsides to withdrawing money from your IRA or 401(k).
- Taxes. If you owe taxes on your withdrawal, the money goes to the IRS and not toward your future home.
- Set back your retirement schedule. You cannot add any more than the annual contribution limit to a retirement plan, so if you take out a withdrawal, it may take you years of saving to make up lost ground.
- And if you tap into your retirement plan to buy your home right off the bat, you may get into the habit of using your retirement savings for other housing issues such as repairs or renovations. Each time you take money out early, it could further impact your progress toward achieving your retirement goals.
Considerations Before Taking a Loan
A 401(k) loan may make more sense than a withdrawal. You can repay that money, and it's not subject to any type of contribution limit because it's a repayment plan. This may be an effective strategy, especially if the extra funds from your 401(k) help lower the cost of your mortgage.
Before you take out a 401(k) loan, make sure you can safely budget both your 401(k) loan and mortgage payments. If you don't follow your 401(k) loan repayment schedule, the plan will count it as a withdrawal, which means you will owe taxes and the 10% withdrawal penalty.
Another consideration when taking out a 401(k) loan is that if you leave your job for any reason, you will need to repay the entire 401(k) loan within 60 days. If you can't, it will count as a withdrawal and incur the IRS charges. This can be quite costly if you don't have the cash to repay the entire loan at once.
While it is possible to both withdraw and borrow money from your retirement plan if you're a first-time homebuyer, you'll want to carefully consider the impact these can have on your overall financial picture first. Use this information to help guide you while deciding whether you should finance the house with your IRA or 401(k), or if you should try to find another source of funds.
