Qualifying for a mortgage has gotten tougher thanks to tighter lending restrictions. Working to boost your credit score and saving up a substantial down payment can improve your odds of getting approved but coming up with the cash is often easier said than done. If you’ve been socking away money in your 401(k) retirement account or an IRA, you may be tempted to use some of that savings toward the purchase of a home.
Generally, taking money out of a retirement account early has some potential tax consequences but the IRS makes some exceptions for prospective homeowners who are dipping their toes in the market for the first time.
Whether you should pull the trigger on using part of your nest egg as a down payment really depends on what type of retirement account you have and how much money you need.
Who qualifies as a first-time buyer?
Obviously, someone who’s never owned a home before is a first-time buyer but the IRS is a little more flexible in its definition. Technically, you can still be considered a first-time as long as you haven’t owned a home in the two years prior to closing on your new property.
If you’re taking money out of an IRA, the first-time buyer in question doesn’t actually have to be you. It could also be your spouse, child, grandchild or stepchild.
Traditional and Roth IRA withdrawal rules
As of 2014, the IRS allows you to withdraw up to $10,000 penalty-free from a traditional or Roth IRA if you qualify as a first-time homebuyer. If you’re married, the limit applies to both of you so you can take out up to $20,000 without having to pay the 10% early withdrawal penalty.
The money can be used toward any costs associated with the purchase of an existing home or the construction of an entirely new property.
While you have the advantage of avoiding a penalty, that doesn’t meant you get off completely scot-free. The contributions that go into a traditional IRA consist of pre-tax dollars, which means you’ll have to pay regular income taxes on the money, regardless of how old you are when you make the withdrawal. If you’re right on the cusp of getting pushed into a higher tax bracket, taking a distribution to buy a home could result in a higher tax liability.
The rules for pulling money out of a Roth IRA are a little more flexible. Withdrawals of contributions aren’t taxed, since these are made with after-tax dollars.
Typically, earnings are subject to income tax but the IRS waives this rule for first-time home-buyers, as long as your account has been open for at least five years. If your IRA has been open for less than five years, you’ll still avoid the penalty but you’ll have to cough up the taxes on the distribution.
Just keep in mind that you have 120 days to use an IRA withdrawal to cover home-buying costs. If you’re still holding on to the money after the deadline, the IRS will consider it to be a regular distribution which means it may be taxable and the early withdrawal penalty will apply.
Borrowing from a 401(k) retirement account
The cost of getting a distribution from your 401(k) retirement account usually outweighs the benefits, since you’ll be on the hook for both taxes and the early withdrawal penalty.
Taking out a loan against your balance, on the other hand, allows you to sidestep the tax implications and you can withdraw quite a bit more compared to an IRA. Currently, you can borrow up to half of the vested benefits in your account, up to a maximum of $50,000.
A 401(k) loan is paid back with interest through automatic payroll deductions so it goes directly back into to your account. How long the repayment period and whether or not you can make new contributions to the plan during this time usually depends on your employer’s preference. Most loans must be repaid within five years, although you may be given up to 15 years to pay it off.
The biggest issue with taking cash out of your 401(k) retirement account is what can happen if you get fired or decide to change jobs. In either of those scenarios, the entire loan balance may be due within 30 to 90 days of leaving your employer. If you can’t come up with the money, you’ll have to report all of it on your taxes, which means you’ll have to pay the early withdrawal penalty on top of a potentially hefty tax bill.
Is pulling from retirement account the right move?
If you don’t have time to save for a down payment or you can’t borrow the money from friends or family, raiding your retirement account may be the best option available. Aside from the potential tax implications, the biggest downside of doing so is that you may be shortchanging yourself in the long run.
Even if you’re paying back a 401(k) loan, the interest you’re paying is likely to be much less than the returns you would have gotten if you’d left the retirement account money alone. You don’t even get the benefit of the interest with an IRA withdrawal.
Ultimately, whether you should tap your retirement account so you can snag your dream home really depends on how comfortable you are with potentially backtracking on your savings progress.