Is the rising cost of real estate endangering your dream of owning a home? There can be many obstacles to home ownership, and perhaps the most common one is the large down payment required upfront.
Are you trying to avoid paying for mortgage insurance? If so, you will need to save 20% of the purchase price for a down payment.
Are you trying to get an FHA loan because it allows for a lower down payment than a traditional (non-government) loan? If so, FHA loans require the home you’re purchasing to be your main residence and you must provide proof of employment plus have a decent credit score, usually greater than 580, to qualify for a 3.5% minimum down payment. If your credit score is lower, then the minimum downpayment on these loans may increase to 10% or more.
With the prices of homes in the bay area skyrocketing, it may seem daunting to save for such a hefty down payment. On top of that, the down payment is only one part of the cash you need throughout the home purchase process.
Fortunately, there is another alternative to securing the funds for a down payment rather than trying to save up for the downpayment – You can use your retirement savings to fund your real estate transaction.
But You Thought Retirement Funds Were Locked Away Until Age 59 1/2!
Usually, your 401(k) and individual retirement accounts are locked up tight until the magical age of 59 and a half so that you can stay on track with your retirement plan. But, because of the importance of owning a home, the IRS has provided exceptions to borrow money or make early withdrawals from their retirement plans.
Although pulling money from your retirement accounts before you retire isn’t the best way to cover your home loans, it is an option. Plus, when done according to the rules, you might not be forced to pay income taxes or pay penalty fees when you withdraw funds.
If securing a down payment to purchase a primary residence is your top priority, then let’s look at a few ways your retirement money can be put to use now.
Using Your 401(k) Retirement Account To Fund Your Home Purchase
There are two options for using your 401(k) retirement account to purchase a primary residence. Withdraw directly from your retirement account or take out a 401(k) loan for the funds needed to secure the home.
When directly withdrawing money from your 401(k) account, two main issues can arise. First, you will likely have to pay an early withdrawal penalty. Second, the IRS will view the money as ordinary income, causing you to pay taxes on the amount withdrawn.
Avoiding Early Withdrawal Penalty and Income Tax
If you must use your 401(k) and you’re focused on preserving your savings AND avoiding taxes, the better option is to apply for a 401(k) loan. This type of loan will help you avoid the early withdrawal penalty and income taxes.
First, check with your retirement account to see if you can take out a loan. Most 401(k) accounts will allow loans, but not all do, so you must see if your account allows for the use of 401(k) loans.
Second, find out how much you can borrow from your 401(k). Many plans allow you to borrow up to half of your savings with an upper limit of $50,000. Knowing how much you can borrow will help you plan for your down payment and make monthly payments to repay the loan.
Using a 401(k) loan has a few additional advantages. 401(k) loans don’t depend on your credit score, so if you have poor credit, this might be one of your best options. The 401(k) loan also doesn’t affect your credit score because this particular type of debt doesn’t count against your debt-to-income ratio. Additionally, because this type of loan doesn’t lower your credit score, you maintain the opportunity to qualify for the lowest mortgage interest rate and, therefore, the monthly payment amount available.
Although a 401(k) loan provides more advantages than a 401(k) withdrawal, you still have to pay yourself back, including the interest on the loan. Usually, you have five years to repay the loan, but you may be able to negotiate for up to 15 years if you are using the loan to buy a house. The interest rate is often several percentage points higher on a 401(k) loan than a traditional loan; therefore, you’ll have to keep that in mind when creating your budget.
Keep a Tight Re-Payment Schedule so You Don’t have to Pay Income Tax
The loan repayment plan can be simplified by using a payroll account deduction. Having this factored into your budget is incredibly important. If you don’t make repayments into the system, the IRS will treat your loan as an early withdrawal, and you will end up paying the 10% early withdrawal penalty and income taxes.
Suppose you lose your job or switch companies. In that case, however, most 401(k) providers will require you to repay the entire loan balance immediately or within sixty days of departure or risk penalties.
How Your IRA Funds Can Buy A House
If you decide against a 401(k) loan or withdrawal, your Roth or Traditional IRA to cover your down payment and help you successfully purchase an esteemed Oakland home.
To encourage you to preserve your savings for retirement, the IRS usually charges a 10% penalty fee and demands income tax from early withdrawals from an individual retirement account (IRA). However, the IRS makes an exception for first-time homebuyers who want to use their retirement accounts for a down payment.
How this works depends on the type of IRA you use.
A Self-Directed IRA (SDIRA) cannot be used to make a home purchase for you or your family. You can use a self-directed IRA to purchase investments only. Primary residences and vacation homes do not qualify.
If using a Traditional IRA, the withdrawal may be up to $10,000 without the 10% penalty, but you still will be on the hook for state and federal income tax. In other words, that money is still viewed as cash income in the withdrawal year.
However, you can file for a hardship withdrawal using your Roth IRA money. This will allow you to withdraw up to $10,000 tax-free and penalty-free to put toward a home purchase.
Before making any of these decisions, check with your financial planner and tax advisor to ensure you understand the long-term costs of withdrawing money out of your Traditional or Roth IRA and to avoid penalties.
Who This Strategy Works Best For and Why You Should Talk with Your Financial Advisor
Don’t dip into your retirement fund immediately if you are struggling to come up with a down payment or to cover closing costs on your home. There are other options for pursuing assistance from the Federal Housing Administration through an FHA loan or exploring alternatives other than your retirement accounts.
However, if you live in or are moving to an area with a high cost of living or are low on liquid savings, using your 401(k) or IRA to fund a down payment on a home purchase may make financial sense for you. A financial advisor will help you determine if you can make the monthly payments required to pay back any loans while still keeping your retirement plan on track.
Disadvantages of Using Retirement Savings To Buy Real Estate
First, let me repeat this: using your retirement savings should be a last resort for purchasing real estate. These accounts are your key to a successful, low-stress retirement season. Withdrawing money from your retirement account should only occur if you have a stable job and a reliable track record of financial discipline and savings.
With a 401k, you will have to pay yourself back in a specific time frame or risk incurring financial penalties. Additionally, any money withdrawn is money you lose in the form of interest. Let’s say you have $100k in a 401(k) and withdraw half. You’ll only earn dividends and compound interest on $50k rather than the full $100k until you repay yourself.
With a Roth IRA, you don’t face these same penalties because there are contribution limits each year. On the flip side, once you’ve taken money from your Roth IRA, the money is gone, and you will have to slowly rebuild this account or come to terms with having a reduced retirement budget and lifestyle than you originally planned for.
Owning your own place is important, but having enough money to thrive after you retire is more important. That being said, you can still safely and strategically withdraw money from your 401(k) or your Roth IRA to purchase the home of your dreams.
Your Retirement Savings Can Work for You Now and in the Future
Using your retirement savings to purchase your house should be your last option, but it is an option you can put to work for you! Homeownership is an investment in your future and your family members’ future.
If you plan well, keep a tight grip on your budget, and continue to make alternative investments, your retirement savings can provide for you now (get into the house you always desired) and in the future! Again, we recommend you work with a financial advisor, do your research, and find an agent you trust before ever making an offer on a new home.
The team at Joe Dickerson Group is in your corner – We’re experienced with both commercial and residential properties in the Oakland, California area and can help guide you through the many potential (real or imagined) financial barriers to becoming a homeowner. Let’s get started!
