Higher interest rates through most of 2022 put pressure on the housing market after home prices hit record highs across the nation. However, since December, mortgage rates have been on a steady decline during the first month of the new year, yet home prices remain relatively high. The median existing-home sales price was up 2.3% to $366,900 in December compared to a year ago, according to the National Association of Realtors (NAR). Though this is the 130th consecutive month of YOY price increases—a record streak—the YOY increase was at a slower pace compared to November. As a result, more and more home buyers are looking for ways to secure the necessary funds needed for a down payment to purchase a home.
In light of the rise in home prices in the last several years, there is a greater need than ever for seeking to use retirement funds to help with a home down payment, This article will discuss the various ways one can use an IRA or 401(k) plan to help with a home down payment.
- Using retirement funds is a popular option among home buyers
- Dipping into retirement savings should only be used after exploring all other options
- Tax consequences make some options less popular than others
How Much do I Have to Put Down to Buy a Home?
Most home buyers believe they must put at least 20 percent down in order to secure the purchase a home. While it’s true that some residential real estate might require a 20 percent down payment, it is not the hard requirement it once was. There are opportunities for some home buyers to receive low- and no-down payment mortgages. The median national down payment was 13 percent in 2022, according to NAR. For a home priced $389,500, that adds up to a $50,635 down payment.
Using Retirement Funds for a Down Payment
Because of the IRS prohibited transaction rules, generally, you cannot directly use retirement funds for a down payment on a house you will live in personally. You, as the retirement account holder, are considered a disqualified person, therefore, you cannot personally benefit from the use of those funds. However, there are ways to use retirement funds to use for a down payment on a primary residence.
$10,000 1st Time Home Buyer Exception
Internal Revenue Code (IRC) Section 72 allows a first time home buyer to take up to $10,000 from his or her IRA to use to purchase a home. The IRA distribution would be subject to tax, but would not be subject to the 10% early distribution penalty if the IRA owner is under the age of 59 1/2. This hardship distribution is only for a first-time home buyer and the taxable distribution cannot exceed $10,000. Unfortunately, a 401(k) plan does not include a hardship exception for first time home buyers.
A taxable distribution from a retirement plan should only be used as a last resort. The ramifications from doing so usually outweigh the benefits. Obviously, the amount withdrawn is taxable during the year it is taken. Plus, if you are under age 59 1/2, you will get hit with an additional 10% early distribution penalty. All other options should be considered before deciding to take a taxable distribution from a traditional retirement plan.
Roth IRA Distribution
The Taxpayer Relief Act of 1997 introduced the Roth IRA. The Roth IRA is an after-tax IRA which allows any U.S. person with earned income under a set income threshold to make after-tax contributions up to $6,500 or $7,500 if age 50 or older for 2023. So long as any Roth IRA has been opened at least five years and the account holder is at least age 59 1/2, all distributions are tax free.
Because contributions have already been taxed, you can withdraw them at any time without tax or penalty. Earnings are subject to the above rules to be deemed a qualified distribution. If the distribution is unqualified, meaning you do not satisfy the conditions above, the distribution is subject to tax and an early withdrawal penalty, if applicable.
The Roth is a great way to save and contributions can always be withdrawn at anytime and for any reason, including a deposit on a home. Once you satisfy the distribution rules, you can withdrawn any amount you want, and it’s all tax- and penalty-free.
If you participate in a 401(k) plan and the plan offers a loan option, you have the opportunity to borrow the lesser of $50,000 of 50% of their account value. According to a study by financial services firm TIAA-CREF released in June 2014, “Nearly one-third (29 percent) of Americans who participate in a 401(k) or other defined contribution retirement plan say they have taken out a loan from the savings in their plan.”
The primary advantage of a 401(k) loan is that the loan proceeds can be used for any purpose, including for the purchase of a home. The loan is generally a five-year loan where payments are due at least quarterly at an interest rate of at least Prime as per the WSJ, which is 7.50% as of February 1, 2023. In addition, some plans allow for the loan term to be greater than five years (up to 15 years in some cases) for the purchase of a home. Further, the interest due on the loan gets paid back into your 401(k) plan.
Gaining the ability to use 401(k) funds without tax or penalty to buy a home, while paying the interest back to your 401(k) plan versus a bank is a popular strategy for many home buyers.
With over $13 trillion dollars of IRA, and $32 trillion dollars of other retirement funds, using one’s IRA or 401(k) to help buy a home is a popular and often needed option. Obviously, other alternatives should be considered first since retirement balances are earmarked for your future. However, if you have no other options, dipping into your savings could benefit you in the short term. No matter what course you choose, you should get back to building up your retirement funds sooner rather than later. Time is always important when it comes to saving in a tax-advantaged plan.