One of the biggest challenges getting in the way for many potential homebuyers is the upfront cost.
On the low end, you’ll typically need no less than 3%-5% for a down payment and an additional 3%-5% for closing costs such as insurance, prepaid taxes and lender fees. As home prices balloon, the amount you need to have saved goes up as well. The average home sale price is now more than $500,000, which means a typical buyer will usually need at least $50,000 set aside for a home purchase.
For those lucky enough to have significant retirement savings in a 401(k) or individual retirement account (IRA), dipping into those accounts to fund a home purchase makes for a tempting option. But robbing your future to pay for your present comes with major tradeoffs.
CNBC Select spoke with Chris Kampitsis, a financial planner with the SKG team at Barnum Financial Group, about how to approach using retirement savings for a home purchase and the best strategies for avoiding taxes and penalties.
3 penalty-free ways to use retirement savings for a home purchase
Retirement accounts are tax-advantaged investment accounts designed to help your money grow for use during your golden years. Because the IRS wants you to use these accounts to fund your retirement, early withdrawals usually come with consequences — you could have to pay taxes on top of a 10% penalty, for example.
Given the restrictions on withdrawing from retirement accounts, you may want to shift where you save money as you plan for a home purchase. “If you know, in a few years, you’re going to want to make a real estate investment, you probably shouldn’t be doing all of your saving into your 401(k),” Kampitsis says. For people expecting to buy a home in the next two to four years, Kampitsis recommends low-risk investment options, such as a high-yield savings account, money market account, Treasuries or I-Bonds.
Right now, some of the best savings accounts have interest rates of 4% or 5%. For example, the Western Alliance Bank Savings Account currently has an annual percentage yield (APY) of over 5% and no monthly fees. And the Marcus by Goldman Sachs High Yield Online Savings account has no monthly fees on top of an APY over 4%.
Although it’s best to use non-retirement accounts to save for a home purchase, there are ways to withdraw retirement funds for a home purchase without paying an additional penalty. But even if you aren’t penalized, you’ll still miss out on the potential investment gains and risk setting back your retirement plans. You need to be extremely confident of your retirement savings and your ability to stay on track before going down this path to homeownership.
Withdraw Roth IRA account contributions
Roth IRA account deposits are considered after-tax contributions, meaning you cannot deduct them from your taxable income. Since you’ve already paid the taxes, you can withdraw the contributions you’ve made to a Roth IRA account at any time without paying additional taxes or a penalty. For example, if you’ve deposited $20,000 into a Roth IRA and your investment has grown to $25,000, you could take out the original $20,000 at any time.
However, taxes, and possibly a 10% penalty, can apply when you make an early withdrawal of investment earnings from a Roth IRA. To avoid these taxes and the penalty, you typically have to have had the IRA open for at least five years and be at least 59.5 years old.
Withdraw up to $10,000 of investment earnings from an IRA for a first-time home purchase
If you’re younger than 59.5 years old, you still have a way to withdraw earnings from either a Roth or traditional IRA without paying a penalty (though you still may be on the hook for taxes).
The IRS allows you to withdraw penalty-free up to $10,000 from an IRA, per person per lifetime, for a first-time home purchase. You qualify as a first-time homebuyer if you haven’t owned a primary residence in the past two years. If you are purchasing a home with a family member or spouse, you each can withdraw up to $10,000 without penalty from your IRAs, provided you both qualify as first-time home buyers.
Traditional IRAs and Roth IRAs have different rules about the taxes you may possibly have to pay on this withdrawal.
- With a Roth IRA, you may owe taxes on the earnings you withdraw if the account is less than five years old.
- With a traditional IRA, you must pay taxes when you take the money out (since unlike a Roth IRA, you don’t pay taxes on the deposits you make). The first-time homebuyer exception allows you to withdraw up to $10,000 penalty-free, but you’ll most likely have to pay taxes on the distribution.
Takeout a 401(k) loan
If you have a 401(k) retirement savings account, you may be able to borrow some of the money you have saved in the account. However, every employer has different rules for 401(k) plans, and a 401(k) loan isn’t always allowed.
Depending on the rules for your 401(k), you may be able to borrow up to 50% of the account balance (up to a maximum of $50,000). The repayment term for these types of loans is typically between 2-5 years. And the interest you pay on a 401(k) loan is deposited into your account, so you’re paying yourself interest on the money.
But there are major caveats to consider with a 401(k) loan, so be sure you understand all the potential risks. If you lose your job or quit, you’ll normally need to repay the loan in full by the following year’s tax deadline, otherwise, you could need to pay taxes and a 10% penalty on the amount you borrowed (if you’re under 59.5 years old). So if you left your job in December, you would have to repay a 401(k) loan in full by the time you file your taxes in April (unless you file for a tax deadline extension).
Depending on your 401(k) plan, you may be able to make contributions and receive an employer match while you’re repaying the loan. However, some plans won’t allow you to contribute to your 401(k) while repaying a loan from it. That means you’d miss out on your company’s 401(k) match in addition to potential investment gains during that time. So be sure to fully understand all of the rules for your specific 401(k) before you make any decision.
Low and no-down payment mortgage options
Before you dip into your retirement savings, be sure to explore all of your other options first. There are loan programs that require little to no down payment. VA loans and USDA loans both require no down payment, and you can get an FHA loan for as little as 3.5% down.
You’ll also want to see if there are any homebuyer assistance programs in your area. These local and state-level initiatives provide down payment and closing cost assistance to eligible homebuyers through grants, forgivable loans and no-interest loans.
Depending on the housing market, you may be able to negotiate and have the seller cover some or all of the closing costs, instead of asking for a lower price. Keep in mind, the amount a buyer can receive from a seller typically can’t exceed the closing costs. The type of mortgage you have can also limit how much the seller can chip in for closing costs.
Bottom line
You can use the money you’ve invested in a retirement account, such as a 401(k) or IRA, to help purchase a home. And in certain situations, it’s even possible to withdraw funds from a retirement account without paying the 10% early distribution penalty.
However, there are significant drawbacks and tradeoffs to pulling money out of your retirement accounts early. So it’s best to exhaust all of your options before tapping your retirement accounts. Look into homebuyer assistance programs, low-downpayment mortgages and consider shifting your savings to a non-retirement account, such as a high-yield savings account, as you plan out your home purchase strategy.
