Retirement Investments: Friend Or Foe In The Quest For Home Ownership?

Using retirement investments to purchase a house is possible, but it may not be a financially wise decision. While it can be a quick way to get cash, it can also have negative consequences in the long term. There are fees and tax consequences to consider, and you may lose out on potential interest and growth in your retirement savings.

Pros of using retirement investments for house purchases

While using retirement investments for a house purchase has its drawbacks, there are several advantages to this approach. Here are some pros of using retirement investments for a house purchase:

Tax Benefits

If you use a Roth IRA for a house purchase, you can take out up to $10,000 as a first-time homebuyer without incurring an early withdrawal penalty. Additionally, you don't have to pay income taxes on this amount since Roth IRAs are funded with after-tax dollars. With a traditional IRA, you can also withdraw up to $10,000 without a penalty for a first-time home purchase, but income tax will apply.

Loan Alternative

Taking a loan from your 401(k) to buy a house is another option. This allows you to borrow from your retirement funds without incurring the early withdrawal penalty or paying income tax on the borrowed amount. However, you will have to repay the loan with interest.

Stability and Control

Owning a home provides more stability and control compared to renting. You won't have to worry about a landlord increasing the rent or selling the property. You also have the option to remodel or make changes to your home, which may not be possible when renting.

Appreciation and Tax Advantages

If you purchase a property as a retirement option, it can appreciate in value over time. This can result in significant gains when you sell the property. Additionally, if you live in the property as your primary residence, you can take advantage of tax benefits and deductions when it comes time to sell.

Diversification

Investing in real estate can provide diversification to your portfolio. It is a different market from stocks and responds to different pressures. By investing in both, you can reduce the risk of putting all your eggs in one basket.

Cons of using retirement investments for house purchases

• Loss of potential growth in retirement savings: The money you withdraw from your retirement account will no longer be accruing interest, which can result in a significant loss of potential growth over time. For example, if you have $20,000 in your account and take out $10,000 for a home, the remaining $10,000 could grow to $54,000 in 25 years with a 7% annualized return. However, if you leave the full $20,000 in your account, it could grow to $108,000 over the same period.
• Fees and penalties: Withdrawing money from your retirement account early usually incurs fees and penalties. For example, withdrawals from a 401(k) before the age of 59 ½ typically incur a 10% early withdrawal penalty, as well as income tax on the amount withdrawn. Similar penalties and taxes may apply to withdrawals from other types of retirement accounts, such as IRAs.
• Reduced savings for retirement: By using your retirement investments to purchase a house, you are diminishing your retirement savings. This can have a negative impact on your future financial security and may not be a wise decision if you do not have sufficient funds to cover your retirement expenses.
• Limited access to cash flow: When you invest in rental property using your retirement account, the income generated by the property is often required to flow back into the account, meaning you do not have immediate access to that cash flow. This can limit your financial flexibility and may impact your ability to make other investments.
• Paperwork and regulations: Investing in rental property through a retirement account can be a complex process with a lot of paperwork and strict regulations. For example, if you invest through an IRA, you cannot live in or actively manage the property, and you must hire a third party to handle all operations.
• Risk of default and high costs: If you take out a loan against your 401(k) to purchase a house and are unable to repay it within the specified timeframe, you may incur high costs. The loan will be treated as an early distribution, resulting in a 10% early withdrawal penalty as well as income taxes owed.

Retirement account withdrawal penalties

Withdrawing money from your retirement account before you reach the age of 59 ½ usually incurs a 10% fee. However, in some cases, you might be able to make an early withdrawal without paying a penalty. Here are some scenarios where you can withdraw money from your retirement account without incurring a penalty:

• Unreimbursed medical bills: The government allows investors to withdraw money from their retirement plans to pay for unreimbursed deductible medical expenses that exceed 10% of their adjusted gross income. The withdrawal must be made in the same year that the medical bills were incurred.
• Disability: To prove disability to the IRS, you must be collecting disability payments from an insurance company or from Social Security.
• Health insurance premiums: You can make penalty-free withdrawals from an IRA if you're unemployed for at least 12 weeks and use the money to pay for health insurance premiums.
• Death: Beneficiaries can withdraw money from a deceased person's retirement account without paying a penalty. However, spouses who inherit an IRA and treat it as their own may be subject to the penalty if they withdraw before turning 59 ½.
• Owing money to the IRS: If the IRS places a levy against your IRA for unpaid taxes, you can take a penalty-free withdrawal.
• First-time home purchase: You can withdraw up to $10,000 from a traditional IRA or Roth IRA without a penalty to buy your first home. Funds must be used within 120 days.
• Higher education expenses: You can generally withdraw money from a 401(k) to cover higher education expenses if the plan allows hardship withdrawals, but a 10% penalty will apply. Withdrawals from an IRA for this purpose are penalty-free.
• Income purposes: Section 72(t) of the tax code allows investors to take money out of their retirement plans for income, but there are restrictions. You must take substantially equal periodic payments over time.

It's important to note that while these scenarios may qualify for a penalty exemption, you may still be subject to taxes on the withdrawn amount. Additionally, early withdrawals from your retirement account can hurt your earning potential by reducing the amount of money that can grow through compounding interest over time. Therefore, it's recommended to consult a financial professional before making any early withdrawals.

Retirement account withdrawal taxes

While it is possible to use retirement savings to buy a home, it is generally not recommended as a first option. Withdrawing money from your retirement account before the age of 59 1/2 usually incurs a 10% fee or tax penalty, though there are some exceptions for first-time homebuyers.

K) Withdrawals

If you withdraw money from a 401(k) before you turn 59 1/2, you will usually be subject to a 10% early withdrawal penalty, in addition to the income tax you will owe on the amount. However, there are two ways to avoid this:

• Take a 401(k) loan: You can borrow from your 401(k) funds to buy a house. This is classed as a loan to yourself, so you don't have to pay the early withdrawal penalty or income tax on the borrowed amount. You will, however, have to pay back the loan with interest.
• Use a Roth 401(k): You can withdraw contributions from a Roth 401(k) without penalty or taxation, but any earnings will be subject to taxation.

Traditional IRA Withdrawals

With a traditional IRA, you can withdraw up to $10,000 without a 10% early withdrawal penalty for a first-time home purchase. However, income tax will still apply.

Roth IRA Withdrawals

With a Roth IRA, you can withdraw up to $10,000 for a first-time home purchase without an early withdrawal penalty or income tax, as these accounts are funded with after-tax dollars. However, you can only withdraw earnings from the account early without penalty and taxation if the account has been open for at least five years.

Other Considerations

While you can use retirement savings to buy a home, it is generally recommended as a last resort. This is because you lose out on potential earnings in your retirement account. For example, if you have $20,000 in your account and take out $10,000 for a home, that remaining $10,000 could grow to $54,274 in 25 years with a 7% annualized return. But if you leave the full $20,000 in your account, it could grow to $108,548 over the same period.

Retirement account alternatives

While it is possible to use your retirement savings to buy a home, it is generally not recommended as a first choice. There are several alternatives to consider before tapping into your retirement funds. Here are some options to explore:

Individual Retirement Accounts (IRAs)

Individual retirement accounts (IRAs) offer special provisions for first-time homebuyers and individuals who haven't owned a primary residence in the last two years. With a traditional IRA, you can withdraw up to $10,000 without the 10% early withdrawal penalty for a first-time home purchase. However, you will still need to pay income tax on the withdrawn amount.

With a Roth IRA, you can withdraw contributions without penalties and taxes, as they have already been taxed. For a first-time home purchase, you can also withdraw up to $10,000 without an early withdrawal penalty. However, any earnings withdrawn early will be subject to taxation.

Low Down Payment Programs

There are various low down payment programs that can make homeownership more accessible. For example, some Conventional loan programs require as little as 3-5% down. Federal Housing Administration (FHA) loans have a minimum down payment requirement of 3.5%, and they offer flexible credit score requirements. United States Department of Agriculture (USDA) loans and Veteran Affairs (VA) loans offer 0% down payments, making them a great option for eligible service members, veterans, or their spouses.

Save More Aggressively

Consider increasing your savings rate to build up a larger down payment. While this may take time, it can help you avoid tapping into your retirement funds. Explore ways to cut expenses or increase your income to accelerate your savings.

Down Payment Assistance Programs

Look into down payment assistance programs offered by federal, state, or local governments, as well as non-profit organizations. These programs can provide grants or low-interest loans to help with the down payment and closing costs.

Negotiate with Sellers

When purchasing a home, consider negotiating with the seller to request their contribution towards closing costs or other expenses. This can help reduce the amount of money you need to bring to the table.

Alternative Housing Options

If buying a home is not urgent, consider alternative housing options such as renting or co-ownership arrangements. This can give you more time to save for a down payment and avoid dipping into your retirement savings.

Remember, it is essential to carefully weigh the pros and cons of using retirement funds for a home purchase. Consult with a financial advisor to assess your individual financial circumstances, goals, and risk tolerance to determine the best course of action.

Frequently asked questions