We recently received the following question from a reader named Sam:
My question: As a first-time home buyer, is it possible to leverage retirement accounts as a down payment? Is this a good idea? Does it matter whether it’s a TSP, Roth IRA, IRA, etc?
I seem to be finding conflicting opinions/statements. The answer is not clear to me.
Great question, Sam! Trust me, you aren't the only person wondering about this. Many people would love to dip into their retirement accounts to help fund a down payment for the purchase of a home. So, let's find out whether you can, if you should, and how to go about doing it.
Using Retirement Accounts to Buy Your First Home
So, can you use money from your retirement accounts for a down payment on your first home? The simple answer is “yes,” but the government doesn’t make it easy.
As you probably know, money that is saved in a qualified retirement plan (like a 401(k) through your employer) or an IRA receives special tax treatment. Frankly, the government doesn’t want a bunch of broke septuagenarians running around. So, they encourage people to save for retirement by providing special tax treatments on these savings.
Retirement accounts are not supposed to be used as savings accounts. The money is meant to be used for retirement purposes only. So, generally speaking, you’re hit with heavy taxes and fees for withdrawing this money before age 59 ½. Typically, this includes paying income taxes on the money now plus a 10% early withdrawal penalty.
Of course, there are some exceptions, and buying your first home is typically one of those. If you decide to go this route, here's how the taxes and fees break down for the most popular types of retirement accounts:
- 401(k) Plans - You’re allowed to take a loan against your 401(k) account under certain circumstances. You can borrow up to the lesser of $50,000 or half of your vested balance. Taxes are not assessed on the money, however, you do have to pay back interest on the loan. If you fail to pay back your loan on time, you’ll be whacked with a 10% early withdrawal penalty.
- Traditional IRAs - With traditional IRAs, first-time homebuyers may use up to $10,000 to put down on a house without fear of a tax penalty. Married couples can increase this amount if both spouses decide to tap into their retirement savings. However, since taxes are deferred on money placed into a traditional IRA, you do have to pay income taxes on that money now.
- Roth IRAs - Because money invested in a Roth IRA is after-tax, you are allowed to withdraw your contributions at any time. However, you may be assessed taxes and penalties if you withdraw any earnings on that money before 5 years of opening your account (or just taxes if you withdraw it after 5 years). With that said, similar to a traditional IRA, you may use up to $10,000 from your Roth IRA toward the purchase of your first home. If your account is less than 5 years old, you may have to pay taxes on the earnings. If your account is more than 5 years old, you should be able to avoid taxes and penalties.
Should You Use Retirement Funds for a Down Payment?
Yes, you can use retirement funds for a down payment on your first house...but, should you?
In my opinion, the answer is clear: No. This is a retirement account, not a savings account. In order for those funds to work their compounding interest magic, you need to keep that money working for you for as long as possible. Borrowing from your future self to pay for what you want right now is rarely a good idea. (Unfortunately, that’s a concept which seems to have escaped most politicians.)
Better Options for Securing Down Payments
There are plenty of good options for making a down payment on your house that don’t involve making withdrawals and risking your financial future. Instead of raiding your retirement accounts, try using one of the following ways to secure a down payment.
Create a Special Savings Account
One of the best ways to save for anything, including a down payment, is to budget for it. Better yet, create a special account that is specifically earmarked for your down payment. Save a predetermined dollar amount or percentage of your income each month. Make sure that the account is liquid so you can easily access the money when you need it. Before long, your down payment savings will grow, and you’ll have enough to put down on your first house.
Pause Other Savings Goals
If you really want to buy a house, it may be time to press the pause button on your other savings goals. Rather than taking distributions on money already in your retirement accounts, simply stop contributing to those plans for now. Take the money you save, and put it in your special “down payment” account. This way, the money you already have in your accounts can continue working for you in conjunction with saving for your down payment.
Rollback Your Lifestyle
Finding ways to cut your expenses can help you save even more for your down payment. Nobody likes to think about cutting back, but this method can be extremely effective. Besides, this is a temporary solution to avoid a long-term nightmare. You can always add things back once you’ve reached your savings goals. But, who knows? You might find you enjoy the extra cash flow you’ve created and decide to keep the cuts for good!
Make Use of Special Loan Products
In the same way that the government encourages saving for retirement, they also encourage homeownership. That’s why they’ve made a number of different loan options available to help first-time homebuyers secure a loan. Here are a few options:
- FHA Loans - If you’re a first-time homebuyer with a short or checkered credit history, an FHA loan may be a good option for you. With a minimum down payment of 3.5% of the purchase price, FHA loans make purchasing your first home more affordable. Be aware that there is a 1.75% upfront premium on the amount of the mortgage and an annual 0.85% premium charged on minimum down payments for 30-year loans.
- USDA Loans - First-time homebuyers living in rural areas may be able to take advantage of the U.S. Department of Agriculture’s rural development loan program. No down payment is required, and there is no private mortgage insurance (PMI) fee. These loans charge an upfront guarantee charge of 2%, which can be wrapped into your monthly payment, with an annual guarantee fee of 0.5% tacked on.
- VA Loans - Servicemembers and veterans who have suitable credit and were discharged under conditions other than “dishonorable” may be eligible to obtain a VA loan. These loans require no down payment, but instead require a funding fee of between 2.15% to 3.30% that can be rolled into the loan payments.
- Navy Federal Credit Union Loans - Active service members and certain civilian employees of the Department of Defense may be eligible for a loan from the Navy Federal Credit Union. Like VA loans, no down payment is required and a funding fee is charged. With these loans, however, the fee is just 1.75%. Again, this fee may be wrapped into the loan.
- Use PMI - If you have good credit and don’t qualify for any of these specialty loans, you might consider making a smaller down payment and paying PMI instead. Nobody likes to pay PMI, but it could work out better for you than taking distributions from your retirement accounts. Do the math for yourself, and see if it is a good option.
While using money from your retirement accounts to secure a down payment for a house is possible, there are better ways to come up with the money. Before raiding your retirement accounts, determine if you are eligible for any of the special financing options mentioned above instead. Trim back your lifestyle, and save as much as you can to make that down payment.
If you’re still having trouble scraping the money together, you may not be able to afford the house you want at this time. Although it can be hard to wait, you don’t want to injure your future financial situation just to get what you want now. By being patient and continuing to save, you’ll be ready to purchase your first home before you know it.