20% Down Alternatives | Using Your 401K or IRA
May 11, 2020 buying into brooklyn,down payment
We talked last week about how challenging it can be to scrape and save enough to make it to that 20% goal for a down payment (especially in Brooklyn) and while there are plenty of alternatives to a traditional mortgage product requiring that hefty down payment, let’s assume for today’s purposes that you’re trying to get there—or as close as possible!
One strategy that is open to you if you already have money in your retirement accounts, is using it to speed up the process. We’ll discuss which accounts don’t penalize you when you use the money to buy a first home, as well as the strategies you can use to save on penalties and taxes.
Using Your IRA for a Home Down Payment
First things first: This is a decision that should be thoroughly considered before acting. That’s because the IRS discourages you from withdrawing money from your retirement accounts early by charging a 10% penalty on withdrawals before you turn 59 1/2.
Among the various kinds of retirement accounts, pulling money from your Roth IRA will cost you the least in taxes and penalties because you can withdraw contributions at any time without penalty or tax. Plus, after you’ve held the account for five years, you can withdraw up to $10,000 in earnings without penalty or tax for the purchase, repair, or remodel of a first home. So if you withdraw all of your contributions, you can still withdraw another $10,000 and not pay the 10% penalty or taxes on any of it.
But there’s an important caveat: you only have 120 days to spend any withdrawn earnings or you may be liable for paying a penalty, though your financial services firm will automatically prioritize the withdrawal of all of your contributions from a Roth IRA before any earnings.
Your next-best option is what’s known as the traditional IRA. You’re still able to withdraw up to $10,000 for the purchase, repair, or remodel of a first home without paying a penalty, but you’ll have to pay regular income tax on the entire amount. Note that SIMPLE and SEP IRAs also follow these same rules.
With a traditional IRA, you must also use the money within 120 days for the purchase of a home or you’ll get hit with the 10% penalty. Alternatively, you can withdraw up to $10,000 penalty free for the purchase of a home for your spouse, parents, children, or grandchildren.
Just as with a Roth IRA, your spouse can also withdraw $10,000 from a traditional IRA, so collectively you could obtain $20,000 penalty-free for a down payment if you’re married. The lifetime limit though is $10,000 per individual.
Using Your 401k for a Down Payment
There’s no specific penalty exemption for home purchases when you pull money out of a 401k, so any money you take out will be classified as a “hardship exemption.” You’ll be assessed a penalty of 10% on the amount withdrawn and you’ll have to pay income tax on it as well.
If possible, roll over the amount you want to withdraw to an IRA, to avoid paying that penalty. But you can’t roll over a 401k that’s with an employer if you’re still working there. If you have an old 401k from a former employer, roll that. A rollover takes time to process so make sure you build that into your timeframe for purchase.
Borrowing from Your 401k
Another option with a 401k is to take out a loan. Your loan can be up to $50,000 (or half the value of the account, whichever is less). As long as you can handle the payments (remember, it’s a loan so you’ll need to pay it back), this is usually a less expensive option than a straight withdrawal. With this option, you’ll pay interest but you won’t pay taxes or penalties on the loan amount.
A few things to keep in mind about 401k loans:
- Since you’re taking on debt and will have new monthly payments on the loan, it may be harder to get a loan.
- The interest rate on 401k loans is generally about two points above the prime rate. The interest you pay, however, isn’t paid to the company – it goes into your 401k account, which takes some of the sting out.
- Many plans give you only five years to repay the loan so make sure you know the repayment time frame or your monthly payment might be substantial.
- If you leave your company, you may be required to pay back the outstanding balance within 60 to 90 days (or be forced to take it as a hardship withdrawal, which means you’ll be hit with taxes and penalties on the amount you still owe.
- If payments are deducted from your paycheck, the principal payments will not be taxed but the interest payments will. Since you’ll be taxed again on withdrawals during retirement, the interest payments will end up being double-taxed—ouch.
Sometimes it makes sense to take a loan from your 401k to cover the down payment, like if you’re getting an FHA loan and only need a small down payment but that large loan payment could have a negative effect on your mortgage qualification.
Let’s look at a $5,000 401k loan. Assuming a 6% interest rate, you’ll have a payment of $93 per month over five years, while a $25,000 loan with the same terms will have a payment of $483 per month. The latter payment could seriously hinder your ability to pay the mortgage every month, and the bank will take this into consideration when figuring what you qualify for.
It’s always best to run numbers and ask your mortgage broker how such a loan will affect your qualification before you take one out. Conversely, if the amount you need will have too adverse an effect on your qualification, it might make sense to withdraw the down payment amount and pay the taxes and penalties.
Mortgage Interest Tax Strategy
Keep in mind that you’ll be deducting mortgage interest on your taxes after you purchase your home. This may “wash” with some or all of the income you report from a retirement account withdrawal.
So let’s say you withdrew $25,000 from your 401k and paid $25,000 in mortgage interest the same year. The $25,000 you’ll report in additional income (from the 401k withdrawal) will “wash” with the $25,000 mortgage interest deduction. In other words, your taxable income won’t be increased by the withdrawal, and you will effectively pay no tax on it.
Pretty good deal, right? But, you’ll still be liable for the 10% penalty, which is $2,500 in this case. This type of strategy can work for IRA, SIMPLE, and SEP withdrawals too. You still won’t be liable for a 10% penalty though unless you withdraw more than $10,000.
Retirement Account Withdrawal Comparison
The best option for you depends on what accounts you have and how much you have contributed to them. In general, you’ll be assessed fewer taxes and penalties if you withdraw money for your down payment from a Roth before a traditional IRA, and from either of those before a 401k. Whether a 401k loan is better than an IRA withdrawal depends on how large it is and whether it will affect your ability to qualify for the amount and type of mortgage you want.
Here’s a quick cheat sheet for what we’ve gone over:
- Contributions in Your Roth IRA: No income tax due, will not owe 10% penalty.
- Earnings in Your Roth IRA up to $10,000 for the Purchase of a First Home: No income tax due, will not owe 10% penalty.
- Small 401k Loan: Will not owe income tax or penalty. Monthly payments will be small and will have a minimal effect on mortgage qualification.
- Any Withdrawal From a Traditional IRA, SEP-IRA, or SIMPLE IRA up to $10,000 for the Purchase of a First Home: Income tax due, will not owe 10% penalty
- Earnings in Your Roth IRA Over $10,000 for the Purchase of a First Home: Income tax due, will owe 10% penalty.
- Any Withdrawal From a Traditional IRA, SEP-IRA, or SIMPLE IRA Over $10,000: Income tax due, will owe 10% penalty
- Large 401k Loan (Limited to Half of Balance or $50,000, Whichever Is Smaller): Will not owe income tax or penalty. Monthly payments can be large and substantially affect mortgage qualification.
- 401k Withdrawal of Any Amount: Will owe income tax and 10% penalty.
The bottom line is that saving up for a down payment can take quite a while. The sooner you get into a home, the sooner you can start saving money on rent and deducting the mortgage interest on your taxes every year!