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Published: Feb 09, 2021 7 min read
Retirmement Savings for a Down Payment, piggy bank in a cage
Martín Elfman for Money

Historically low interest rates have made home loans more affordable for many borrowers. But being able to manage the monthly payments is just half the battle. For many, coming up with the down payment is the hardest part.

Last year 87% of all homebuyers financed their purchase, according to the National Association of Realtors. Of those, 11% said coming up with the money for a down payment was the most difficult step of the homebuying process. While many relied on cash savings or selling another home, 7% of homebuyers took money out of their retirement funds.

There are generally large penalties for taking money out of a tax-advantaged account before you reach retirement age. The laws around 401(k)s and individual retirement accounts (IRAs) make some exceptions for homebuyers, particularly first-time buyers, but is using your retirement savings for a down payment a good idea?

Generally, no.

Withdrawal penalties, interest payments and taxes

Unless you are older than 59 1/2, withdrawals you make from a 401(k) will be subject to a 10% penalty, as well as income taxes.

If your 401(k) plan provider allows loans, you could borrow up to $50,000, or half your vested account balance, whichever is lower. But, as with any loan, you’ll have to pay yourself back — with interest. The rate charged on a 401(k) loan is usually the prime rate plus 1% or 2%, but your actual rate will be set by your plan provider.

You’ll typically have five years to pay back the loan, although the term could be extended up to 15 years if you’re purchasing a primary residence. Some plans also won’t let you continue making contributions to the account until the loan has been repaid in full.

If you are more than 90 days late with a payment, the remaining loan balance will automatically be considered a distribution and be subject to a 10% early withdrawal penalty and income taxes. If you lose or leave your job before the loan is repaid, you will have 60 to 90 days to pay the balance before owing the 10% penalty and taxes..

IRAs are a little more lenient: a first-time homebuyer can make a one-time $10,000 withdrawal without paying a penalty. The IRS defines a first-time homebuyer as someone who hasn’t owned a primary residence in the last two years. You will, however, owe income tax on the withdrawn amount.

Lost savings

“When deciding if it is a good idea or a bad idea, it all comes down to the client’s personal situation, current income and cash flows, and overall financial picture,” says Nina Gunderson, a financial advisor at UBS Wealth Management USA in New York.

However, Gunderson and other experts say that using retirement savings to buy a house should be the last option you consider. Jimmy Lee, CEO of Wealth Consulting Group in Las Vegas, notes that using retirement funds for non-retirement purposes can leave you in a precarious situation at an age when you need the most financial security.

“If you don’t have the money for a down payment, taking money out of an IRA or a 401(k) is not a good idea,” says Lee. “That’s going to make your retirement picture not look very good.”

You are not only dropping your savings balance down immediately but also losing out on the investment gains you would have accumulated over time if the money stayed in your account. For example, $10,000 invested would grow to around $18,000 over a 10 year time period, assuming a 6% annual rate of return.

One rule of thumb says that, in order to maintain your current lifestyle in retirement, you should have 10 times your income saved by age 67. Removing any money is going to make that exceedingly difficult — especially if it’s subject to penalties and tax obligations.

Making up for lost time will not be easy. Loan payments can be steep, and just because you withdraw money does not mean you are allowed to exceed annual contribution limits if you want to restore it, so it may take several years to replace the investment even if you have the money. The limit for a 401(k) is $19,500 for 2021 (people over 50 can go up to $26,000). With an IRA, it’s $6,000 ($7,000 if you’re older than 50).

You may also find that having to raid your retirement fund is a good indication that you should wait before buying a home. As Lee points out, “it’s probably better, if you don’t have the money, to not go shopping for a house.”

Why a Roth IRA is your best option

If you absolutely have to use retirement savings to fund a down payment, your best option would be to use a Roth IRA, especially if you have other savings you can rely on in retirement.

Roth IRAs rules are a little different. Because you pay taxes on Roth funds before they enter your account, you can withdraw your contributions without penalty and without having to pay additional taxes.

Once you’ve withdrawn all of your principal, you can then withdraw up to $10,000 of earnings for a primary home without penalty like with a traditional IRA. If you withdraw more than $10,000, you’ll pay a 10% penalty on the additional amount.

However, as with any withdrawal, you will lose out on the accrued interest your money would have accumulated over time.

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