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Christine Benz

Retirement Planning > Saving for Retirement > IRAs

4 Ways to Use Retirement Savings to Buy a Home (if You Must): Morningstar

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Homebuying can be stressful, but even more so for those doing it for the first time. The healthy housing market, combined with low mortgage interest rates (despite the Federal Reserve’s plan for rate hikes), makes now a good time to buy a home, says Christine Benz, director of personal finance for Morningstar, in a new column.

Ideally, Benz says, buyers should “fund a home purchase with non-retirement assets — money held in a taxable brokerage account.” And the need to dip into retirement savings might be a “red flag” that a home purchase is unaffordable, she writes.

However, especially for younger people, retirement savings may be the only option to fund a down payment. Plus, some types of retirement accounts allow withdrawals for first-time home purchases, Benz points out.

So from “least bad” to “very worst,” according to Benz, here are four ways to tap retirement savings to fund a home purchase.

1. Roth IRA

Of retirement accounts, this is the best type to withdraw from, Benz writes, “because you can withdraw your own contributions (no investment earnings) for any reason without incurring taxes or penalties.” Taxes have already been paid on these contributions.

If withdrawing earnings on the Roth IRA, there are certain “strictures” especially if you’re younger than 59 ½. “However, if you’ve had the money in the Roth IRA for five years or more but you’re not yet 59 ½, you can tap the investment-gain piece of the Roth IRA without penalties or taxes under certain circumstances, including if you’re making a first-time home purchase.”

The limit for first-time homebuyers is $10,000, she notes.

If the Roth is less than five years old, she points out, the withdrawal will be taxed — if someone is in a 25% tax bracket, withdrawing $10,000 means a reduction to $7,500 once taxes take their bite.

2. Traditional IRA Withdrawals

Those withdrawing before 59 ½  can avoid the 10% early withdrawal penalty, Benz says, if the assets, up to $10,000, are used for a first-time home purchase.

However, traditional IRA withdrawals are subject to income tax, based on the ratio of assets in the account that have never been taxed to those that have.

“For investors whose IRAs consist entirely of deductible contributions, rollover assets and former employers’ 401(k) plans, and investment earnings, the distribution would be 100% taxable at the investor’s ordinary income tax rate,” Benz says.

But if the IRA was a blend of already-taxed and non-taxed money, a ratio would kick in. For instance, if the account was made up of 70% deductible contributions/investment earnings and 30% nondeductible, the withdrawal would be 70% taxable, she says.

3. 401(k) Loans

This is the better of two options: 401(k) loans and withdrawals (see below). A big plus of the loan is interest is paid back into the 401(k) accounts as opposed to a bank, Benz says. Also, there is a limit: the lesser of $50,000 or 50% of the vested account balance.

The “dicey” part, says Benz, is that there is a typical term of five years to repay the loan. This payback on top of a new mortgage “could present financial hardship,” Benz writes.

Further, the 401(k) loan could affect how much you can borrow from the bank for the home loan.

And, a worst-case scenario is if you lose your job. That means the full amount borrowed from the 401(k) would need to be paid back within 60 to 90 days. If you can’t, says Benz, “the withdrawal will count as an early distribution and be subject to ordinary income tax as well as a 10% penalty.”

4. 401(k) Withdrawals

Try to avoid this option, Benz says. Unlike IRA withdrawals, taking money out of a 401(k) means paying a 10% penalty as well as ordinary income tax. So for an investor in the 25% income tax bracket, an early 401(k) withdrawal of $25,000 would be reduced to $16,250 once penalties and taxes are factored in.