Many experts think this is a great time to buy a new house, especially if you are a first time home-buyer. Interest rates are low and home values are depressed. The problem, however, with this credit crunch is having enough cash for the down-payment. There are programs out there so that you can buy a home with almost no money down, but that can lead to the monthly payment of Private Mortgage Insurance (PMI), which is expensive, and opens the homeowner to the possibility of owing more than the home is worth if the value declines.
In order to put have an adequate down-payment, many prospective homeowners will consider dipping into their IRAs, 401(k)s or 403(b)s for the down payment. Tapping into these retirement accounts options have significant drawbacks and the cost of such withdrawals should be carefully considered.
IRAs
Best features:
* You can withdraw up to $10,000 without a 10% early withdrawal penalty. (A husband and wife can each withdraw $10,000 to make a $20,000 down-payment.)
* You may withdraw for immediate family such as a spouse, child, grandchild, parent or other ancestor.
Pitfalls:
* The withdrawal amount will be taxable as ordinary income.
* There is no ability to re-contribute money.
* Funds can only be used towards: buying, building or rebuilding the primary residence; and any usual or reasonable settlement, financing or other closing costs.
401(k)s/403(b)s
401(k)s and 403(b)s function in very similar fashion to each other. There are 2 ways to access your retirement fund to purchase a home: withdrawing it outright, or taking a loan out against it. It is usually a far better option to borrow against a 401(k)/403(b) than to withdraw from it due to the pitfalls.
1. If you withdraw money from your 401(k)/403(b):
Best features
* You do not have to be a first-time homebuyer to withdraw 401(k)/403(b) funds (any financial hardship as described by the IRS will suffice).
Pitfalls
* You need to be purchasing a primary residence, as withdrawals are only permitted under “hardship” circumstances. (The government considers the need to purchase a primary residence as a hardship circumstance.)
* The withdrawal amount will be considered taxable income.
* You will be assessed a 10% early withdrawal penalty if you are under age 59.5.
* You lose the compounding interest.
* You may also be prohibited from making any additional contributions for a period of one year.
2. If you borrow against your 401(k)/403(b):
Best Features
* You may borrow the lesser of $50,000 or ½ of your account balance. However, if ½ your account balance is less than $10,000, it may be possible to borrow $10,000.
* A loan from a 401(k) allows you time to pay it back. (This is usually at prime + 1% and the typical payback period is 10-15 years, but it may be as long as 30 years.) A 403(b) typically has a payback period equal to the duration of the first mortgage. However, you should check the specific payback period identified in your plan.
* There is no penalty for borrowing against your 401(k).
* Assuming that you pay the loan back in a timely manner, there are no adverse income tax consequences to receiving the loan.
Pitfalls
* If you lose your job, any unpaid loan amount would either be due in a period as short as 60 days. If you do not pay back the loan, the unpaid amount will be considered income, which is then both taxable and possibly also subject to a 10% early withdrawal penalty.
* Most plans prevent you from contributing extra savings until the loan is repaid.
Conclusion
While IRA, 401(k) and 403(b) funds could be used to fund the deposit on a first time home purchase, the tax drawbacks and risks are significant. You will want to consider how use of these funds will affect your retirement and your estate and the tax implications before taking such drastic measures. Obviously, if you are in your 20s with many years until retirement, and perhaps not at the peak of your earning potential, the use of your IRA and/or 401(k) and/or 403(b) funds can help you buy a piece of the American dream. However, if you are looking towards retirement or the rate of return on these funds makes withdrawing funds a particularly costly proposition, it is best to look elsewhere for your down-payment.
Special thanks to Nancy McMillin in the preparation of this post.
In order to put have an adequate down-payment, many prospective homeowners will consider dipping into their IRAs, 401(k)s or 403(b)s for the down payment. Tapping into these retirement accounts options have significant drawbacks and the cost of such withdrawals should be carefully considered.
IRAs
Best features:
* You can withdraw up to $10,000 without a 10% early withdrawal penalty. (A husband and wife can each withdraw $10,000 to make a $20,000 down-payment.)
* You may withdraw for immediate family such as a spouse, child, grandchild, parent or other ancestor.
Pitfalls:
* The withdrawal amount will be taxable as ordinary income.
* There is no ability to re-contribute money.
* Funds can only be used towards: buying, building or rebuilding the primary residence; and any usual or reasonable settlement, financing or other closing costs.
401(k)s/403(b)s
401(k)s and 403(b)s function in very similar fashion to each other. There are 2 ways to access your retirement fund to purchase a home: withdrawing it outright, or taking a loan out against it. It is usually a far better option to borrow against a 401(k)/403(b) than to withdraw from it due to the pitfalls.
1. If you withdraw money from your 401(k)/403(b):
Best features
* You do not have to be a first-time homebuyer to withdraw 401(k)/403(b) funds (any financial hardship as described by the IRS will suffice).
Pitfalls
* You need to be purchasing a primary residence, as withdrawals are only permitted under “hardship” circumstances. (The government considers the need to purchase a primary residence as a hardship circumstance.)
* The withdrawal amount will be considered taxable income.
* You will be assessed a 10% early withdrawal penalty if you are under age 59.5.
* You lose the compounding interest.
* You may also be prohibited from making any additional contributions for a period of one year.
2. If you borrow against your 401(k)/403(b):
Best Features
* You may borrow the lesser of $50,000 or ½ of your account balance. However, if ½ your account balance is less than $10,000, it may be possible to borrow $10,000.
* A loan from a 401(k) allows you time to pay it back. (This is usually at prime + 1% and the typical payback period is 10-15 years, but it may be as long as 30 years.) A 403(b) typically has a payback period equal to the duration of the first mortgage. However, you should check the specific payback period identified in your plan.
* There is no penalty for borrowing against your 401(k).
* Assuming that you pay the loan back in a timely manner, there are no adverse income tax consequences to receiving the loan.
Pitfalls
* If you lose your job, any unpaid loan amount would either be due in a period as short as 60 days. If you do not pay back the loan, the unpaid amount will be considered income, which is then both taxable and possibly also subject to a 10% early withdrawal penalty.
* Most plans prevent you from contributing extra savings until the loan is repaid.
Conclusion
While IRA, 401(k) and 403(b) funds could be used to fund the deposit on a first time home purchase, the tax drawbacks and risks are significant. You will want to consider how use of these funds will affect your retirement and your estate and the tax implications before taking such drastic measures. Obviously, if you are in your 20s with many years until retirement, and perhaps not at the peak of your earning potential, the use of your IRA and/or 401(k) and/or 403(b) funds can help you buy a piece of the American dream. However, if you are looking towards retirement or the rate of return on these funds makes withdrawing funds a particularly costly proposition, it is best to look elsewhere for your down-payment.
Special thanks to Nancy McMillin in the preparation of this post.
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