There are few ways for clients with assets in traditional 401(k) plans or individual retirement accounts to access those funds penalty-free before reaching age 59.5 — and that’s by design.
Early withdrawals generally entail a 10% penalty on top of the normal income taxes owed, with the idea being to incentivize Americans to put money away for retirement and keep it invested over long periods.
This penalty may be waived in a variety of cases, however, including for first-time homebuyers withdrawing IRA funds to make a down payment. These homebuyers can withdraw up to $10,000 for a down payment without incurring the 10% penalty — although they’ll still pay income taxes on the withdrawal. Those with 401(k) accounts can't make such withdrawals, but they have the opportunity to draw a loan from their account, generally up to the lesser of $50,000 or 50% of their total account balance.
The ability to tap retirement assets this way can be a great tool for would-be homebuyers, according to Ed Slott and Jeff Levine, but it also shouldn’t be used lightly.
The retirement income planning experts, both CPAs, address the topic on the latest episode of the Great Retirement Debate podcast. As they emphasize, prioritizing the purchase of a home over the accumulation of future retirement wealth is a decision that should be made as part of an overall financial plan.
“If you take money out of your IRA or any other type of retirement account, you are reducing the amount of money you're going to have available later at a time of your life when it may be harder to work,” Levine warned. “They’re called retirement accounts for a reason.”
Of course, Slott contended, there is more to many financial decisions than math.
“There are stages of life where things are really important for you,” Levine said. “For a lot of people who are starting and raising families, there's really not a price you can put on having a home to do that. … There's a non-financial element to this decision, and some people may be willing to sacrifice their future standard of living in retirement to own a home today.”
Many clients are likely already homeowners, Slott and Levine noted, but their children might not be. That makes the home-purchase penalty exception a great multi-generational planning topic, one that can help advisors build credibility and trust with potential future clients.
To Withdraw or Borrow?
For clients using a 401(k) to support a home purchase, the experts discussed, there are two ways to access the funds: a 401(k) loan or a withdrawal from the account.
Generally, Slott and Levine agreed, it’s better to take out a loan against the 401(k) rather than cashing it out. This allows clients to avoid the 10% early withdrawal penalty and puts them on track to "repay themselves" over time. While they'll likely miss out on returns from equities they would have owned, paying back the loan with interest will help them recoup some ground.
Under Internal Revenue Service rules, with a 401(k) loan, clients can usually borrow up to the lesser of $50,000 or 50% of the account balance. Those with smaller account balances are entitled to a minimum $10,000 loan. This limit is reduced by any other outstanding loans from their employer's plans issued in the past 12 months, and loans must typically be repaid within five years with level payments. Longer time periods may be permitted for primary home purchases.
These features are appealing, Slott and Levine said, but borrowing against a 401(k) means they will need to pay interest on the loan. That can add significant strain to a family's budget, so it’s a good idea to talk to an advisor to understand the conditions before they borrow against retirement assets.
“It’s also important to note that not all retirement plans allows loans,” Slott warned. “It’s a matter of discretion for the employer, but many of them do allow this.”
Another key factor in the loan-consideration process, Slott and Levine said, is the interest rate environment. When rates are higher, borrowers must pay lenders a greater monthly amount to access the loan.
“In many cases, it can be more appealing to be paying yourself back at the higher rate versus paying the interest rate to the bank,” Levine said. “But in either case, you need to make sure you can afford to pay back that loan.”
Critically, the duo emphasized, these loan rules apply only for 401(k) plans. Clients cannot take a direct loan from a traditional or Roth IRA. If they do, it's considered a prohibited transaction by the IRS that can trigger major tax consequences. For that reason, Slott and Levine said, IRA-only owners can consider only the penalty-free withdrawal route for a qualifying first-time home purchase, although the amount is limited to $10,000.
In some outlying cases, Slott and Levine said, clients may choose to make bigger withdrawals from the IRA or make withdrawals from their 401(k). This will require them to pay significant taxes and penalties, but that may be "worth it" in some scenarios where homeownership is the primary goal.
For clients with a strong goal of owning a home within a few years, Levine added, it's probably better to save in a non-retirement account that won't bring in any of this complexity.
Roth IRA Withdrawals
Roth IRAs, in this context, work somewhat differently from traditional IRAs.
A recent analysis published by the asset manager Lord Abbett offers a case study that assumes an individual has a Roth IRA valued at $50,000, with the account composed of $40,000 in contributions and $10,000 in earnings that meet the five-year rule. The first-time home purchase withdrawal could be up to $50,000 without being subject to income tax or the 10% early distribution penalty.
This is the case because the $10,000 exception applies only to funds that would otherwise be subject to the 10% early distribution penalty tax — not to post-tax contributions.
Potential Role of Roth Conversions
In closing the podcast, Slott and Levine consider another potential pathway for would-be homebuyers to efficiently tap retirement assets via Roth conversions.
They take the example of a 25-year-old worker who has been diligently saving for retirement since starting a career a few years earlier, having amassed $70,000 in a 401(k).
“That amount could easily grow to be $120,000 or more by the time they are 30 and are looking to buy a first home,” Slott noted. “This raises the idea of moving some or all of the money into a Roth account via strategic conversions. If they make the conversion at least five years before the home purchase, they won’t have to pay taxes or penalties on the future withdrawals of principal.”
Levine added: “You don’t even have to go down the conversion path. If you’re a worker with limited funds, Roth IRA contributions could be a good way to go, because you’re paying the tax now at a lower rate and accumulating funds that could be used for either retirement or potentially a future home purchase. Roths are a good parking place for future planning.”
Pictured: Jeff Levine, left, and Ed Slott
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