If you're straining to come up with funds for a down payment for your home, you may be tempted to tap one of your retirement accounts. In principle, it's not a good idea, since you'll need those funds for retirement and you could end up paying a heavy tax price. But in certain circumstances, it may be a reasonable approach.
Generally, a straight withdrawal from a pre-tax 401(k) or traditional individual retirement account is a bad idea--it's simply too costly. The distribution will be taxed as ordinary income at federal rates up to 35%, there are state income taxes to fork over, and there's usually a 10% federal penalty too.
But if you're a younger person buying your first home, a modest out-and-out withdrawal from a traditional IRA can make some sense, says Mike Johnson, a principal at St. Louis-based Moneta Group, a financial planning firm. That's because the law allows first-time home buyers to draw up to $10,000 from a traditional IRA account without being hit by the 10% penalty, so long as the funds are used for a home purchase within 120 days. (For more on how to get money out of a retirement account without penalty, (Click link>>)
How To Tap Retirement Funds Penalty-Free - Forbes.com
Since your withdrawal will be taxed, try to time the withdrawal and the home purchase early in the year. That way, you'll maximize the mortgage-interest deductions for the year, offsetting some or all of the extra income. (Remember, any points you pay on the initial mortgage to buy a home are deductible in the first year.) If your purchase falls through, be sure to roll the money back into an IRA within the 120 days to avoid taxes and a penalty. (This is a special time. Normally, you have only 60 days to complete an IRA rollover. For more on rollover rules and what happens if you miss a rollover deadline, (Click link>>)
The Dog Ate My IRA Rollover - Forbes.com
Another approach that can make sense is withdrawing money from a Roth IRA. The contributions you made to the Roth weren't tax deductible to begin with, and you can withdraw your original contributions (not the earnings) at any time without owing any taxes or penalty. That flexibility is one reason why Roths are a good vehicle for young folks who want to save for retirement, but worry they might need the money for other expenses first. (For more on the advantages of a Roth, (Click link>>)
Retirement Savings, Without The Strings - Forbes.com
The downside? By depleting your Roth, you're giving up a valuable hedge against future higher tax rates, since all withdrawals from a Roth in retirement are tax free.
What about tapping your 401(k)? In most cases, you'll want to forget about an out-and-out withdrawal and work instead with your employer to arrange to take a loan from your 401(k) account. The law allows you to borrow up to half your vested balance or $50,000, whichever is less, without triggering taxes or a penalty.
If you've already maxed out the amount you can borrow from your 401(k), the law also allows you to take a "hardship" withdrawal from a 401(k) to buy (or keep) a primary home. But you'll be socked with both ordinary taxes and the 10% penalty for this withdrawal, and you'll be barred from contributing to your 401(k) for six months. (Note that while the law allows for both loans and hardship withdrawals, your employer doesn't have to permit either of them and can limit the circumstances in which they're allowed. So, for example, your employer might not consider your desire to buy a home a "hardship.")
Borrowing from your 401(k) isn't like pledging retirement funds as security for a bank loan--you'll really be selling stocks or bonds owned in the account and using the proceeds to fund your loan to yourself. You'll make principal and interest payments back into your 401(k). So where your 401(k) previously owned stocks or bonds, it will now own a fixed-income investment in you. The interest rate is set by your employer, usually at a percentage point or two above the Libor or Prime rate. Normally, loans from a 401(k) must be paid back within five years. But for a home purchase, an employer can agree to a 15-year repayment schedule.
Proceed with caution here: If you leave your job, your employer is likely to demand immediate repayment of the loan. If you can't come up with the cash, it will be treated as a withdrawal, again subject to both ordinary income taxes and (assuming you're young) a 10%early withdrawal penalty.
