Should You Use Your 401(k) or IRA As a Down Payment on a House?

Most homebuyers can’t afford to pay cash for the total value of their home.

For many investors, 401(k) plans and individual retirement accounts represent a significant asset.

Retirement funds might seem like a source of ready cash for a home purchase. Yet, they carry many restrictions on withdrawals.

You may face taxes or even penalties if you tap your accounts for a down payment on a house.

However, there are ways to work within these restrictions to get at least some of the money you need. The question is, just because you can access these funds, does it mean you should?

Avoiding Private Mortgage Insurance

Homebuyers usually put up a down payment and finance the balance through a home mortgage. A down payment of 20 percent is standard in the industry.

Below this amount, buyers may have to pay for private mortgage insurance. PMI is insurance for the lender in case the buyer cannot make their mortgage payments.

The added cost of PMI makes putting down less than 20 percent of a home’s value more expensive.

The problem for cash-strapped homebuyers is that even a 20 percent down payment can still be a lot of money.

If you don’t have tens of thousands of dollars in cash for a down payment, you might be tempted to withdraw from your retirement accounts.

401(k) Down Payment Withdrawal Rules

One way to get money out of a 401(k) for a down payment is to take a straight distribution.

Generally, you can’t take money out of a 401(k) unless you die, leave your job after age 55, become disabled, reach age 59 ½, or your plan terminates.

However, you might be able to take a hardship withdrawal if you don’t qualify for a more traditional 401(k) distribution.

Hardship withdrawal

The IRS allows hardship withdrawals if you have an “immediate and heavy financial need.”

One of the qualifying circumstances for a hardship withdrawal is the purchase of a principal residence. Under this scenario, the money you withdraw can only be used for this purpose, and you cannot withdraw more than you need.

You can only withdraw your contributions -- and in some cases, those of your employer -- but not your earnings.

Hardship withdrawals are taxable as ordinary income, just like with more traditional 401(k) distributions. If you’re withdrawing a significant amount from your 401(k) to pay your down payment, you may find yourself in a higher tax bracket.

Taxes and penalties

If you’re under age 59 ½, you’ll also owe a 10 percent early withdrawal penalty.

An early 401(k) distribution may cost a high-bracket taxpayer more than 50 percent of the amount of the distribution.

401(k) loan

One way to avoid taxation and penalties is to consider a 401(k) loan rather than a distribution. The IRS permits loans in all 401(k) plans. Whether or not they are offered is up to the individual plan custodians.

If your plan allows loans, you can borrow up to 50 percent of your 401(k) account balance, up to a maximum of $50,000. You’ll have to repay the money over a term no longer than five years.

One of the key benefits of a 401(k) loan is that you pay back the principal and interest to your own account.

The other main benefit is that the loan is not subject to taxes or penalties.

However, if you leave your job, your entire loan balance must be paid back, often over a period as rapid as 60 to 90 days.

Failure to pay back the loan results in taxation of the outstanding balance. If you’re under age 59 ½, you’ll also face the 10 percent early distribution penalty.

IRA Down Payment Withdrawal Rules

Unlike with 401(k) plans, loans are not permissible from IRA accounts. If you want to use the money in your IRA to make a down payment on a house, you’re going to have to take a distribution.

Distributions from traditional IRAs are generally fully taxable as ordinary income.

The only exception is if you made any after-tax contributions to a Roth IRA.

These contributions can be taken out tax-free. Earnings are always taxable when withdrawn from an IRA, regardless of the contribution source.

If you’re under age 59 ½, you’ll pay a 10 percent early distribution penalty on both contributions and earnings.

Traditional IRA Vs. Roth IRA

Exceptions

There is an important exception to these rules for traditional IRA distributions.

The IRS permits penalty-free withdrawals from a traditional IRA for first-time home buyer expenses.

There are limitations to this exception, however.

You must qualify as a first-time home buyer, and you cannot take out more than $10,000.

You are still subject to ordinary income tax on the amount you withdraw. However, you can avoid the 10 percent early distribution penalty.

Different rules for Roth IRAs

Roth IRAs have slightly different rules.

Roth IRAs are funded with after-tax money.

You can always withdraw your contributions from a Roth IRA tax-free, making them viable candidates for down payment funds.

If you take out your earnings, however, you’ll pay ordinary income tax unless you’ve had your Roth account open for at least five years and are over age 59 ½.

If not, those earnings are taxable. You’ll also face the same 10 percent early withdrawal penalty as with traditional IRAs on any earnings you take out before age 59 ½.

In one sense, Roth IRAs have a bit more flexibility when it comes to being used as a source of down payment funds. With Roth IRAs, the same $10,000 limit for first-time homebuyers exists.

However, since you can also take out contributions tax- and penalty-free, that $10,000 limit applies to earnings only.

This means the total amount you can withdraw from a Roth for your home down payment will usually be higher. You can take out both your contributions and up to $10,000 in earnings.

Definition of "First-Time Homebuyer"

A first-time homebuyer exception of $10,000 may not sound like much, especially with the median down payment running over $42,000.

However, the IRS defines “first-time homebuyer” quite broadly.

You’re obviously a first-time homebuyer if this is your first home purchase. But, according to the IRS, you also qualify if you and your spouse have not owned a principal residence at any time over the prior two years.

There are a few interesting ramifications of this rule.

Vacation home

Since the IRS refers to owning a “principal” residence, it means the exemption still applies even if you own a vacation home the entire time.

Two-year rolling period

It means that even if you buy and sell homes repeatedly, you can qualify for the exemption every two years.

Buying for others

You don’t even have to be an actual homebuyer to qualify. If you’re using the money to help a relative buy a home, for example, you can still qualify as a “first-time homebuyer.”

The catch

While these seem like nifty ways around the “first-time homebuyer” exemption, there’s a catch.

The $10,000 limit for first-time homebuyers is a lifetime limit.

Once you reach the $10,000 total limit from your IRA using this exemption, you can never use it again.

Should You Use This Option?

There are ways to get money out of your retirement accounts to use as a down payment on a house.

However, there are lots of strings attached.

If you’re tapping your 401(k), expect taxes and penalties unless you’re borrowing the money. The downside of a 401(k) loan, of course, is that now you’ve got an added monthly expense as you pay the loan back.

Getting the money out of your IRA can also result in taxes and penalties.

You can sidestep these costs by withdrawing Roth contributions or after-tax traditional IRA contributions. You can also avoid penalties by availing the $10,000 first-time homebuyer exception, although you’ll still owe taxes.

Beyond these more visible costs, you’ll be incurring a significant hidden cost as well.

By taking money out of your retirement accounts, you’re losing the potential growth in your savings.

Let’s say you take just $10,000 out of your IRA at age 30 to buy a home. If you instead kept that money in your account and it grew at 8% per year, by age 60, that $10,000 could have grown to over $100,000.

Use this option only when absolutely necessary.

What’s the Bottom Line?

The bottom line is that raiding your retirement accounts for a down payment can jeopardize your long-term savings.

It can also trigger short-term taxes and penalties.

You’ll have to balance these expenses against the potential benefits of using the money to buy a home.

For starters, the value of your home may appreciate and offset these costs. You may also reap significant financial rewards if you use the money to avoid PMI.

As with any major financial decision, you’ll have to review the pros and cons if you want to choose the best course of action.

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