“I’m buying a home and planning on putting 5% down. But would it be better to take money from my retirement savings and put more money down?"
We hear this question quite often. Many home buyers wonder if they should borrow money from their 401(k) or IRA to help them buy a home. But these home buyers are under the impression they have to make a 20% down payment on their home and want to get as close as possible. But the 20% down payment is just a myth - you have other options. But if you’re under that impression, it may be tempting to dip into long-term investments to make a larger down payment.
In this article, we'll will give you a 30,000 foot fly-over answer to this simple but complex question about borrowing from your retirement savings to increase your down payment on your home mortgage.
Understand your 401(k) or IRA withdrawal details.
First things first - it is never or very rarely recommended to borrow against your retirement savings. But...
If you have thought about borrowing against your IRA, you technically can't take a loan directly from it. But you can take money out of it to put back into it or another qualified tax-advantage account within 60-days. If you miss that window, you'll begin paying withdrawal penalties and owe taxes. However, you'll need to see if your IRA is even eligible for this in the first place.
If you are considering dipping into your 401(k), here are some important details to know about your plan:
- Verify your 401(k) allows for a loan.
- Verify your max loan amount allowable.
- What are the repayment terms?
- If you leave the company, when must the loan be repaid?
- Is your borrowed money earning anything while being borrowed?
For 401(k)s specifically, there’s no regulation from you withdrawing your qualified money before you are 70.5 years old. But under your company 401(k), are you restricted? There’s a 10% tax penalty unless you take a loan from your 401(k) with a promise to pay it back.
However, this does not mean you should borrow from your 401(k) or IRA to help purchase a home.
Dipping in early can sting later.
Although it seems like a worthwhile decision, borrowing against your savings early has long-term negative effects.
For IRAs, as long as you pay back the loan within 60-days, no tax or penalties apply. Self Directed Retirement Plans outlines everything you'd need to know here and the financial dangers. The big and obvious risk is missing the 60-day window. If you were trying to use this money to help with a down payment and pay it back in time, but the mortgage closing had delays or expected money gets tied up...you're now in it pretty deep. Income taxes will apply and you'll owe a 10% early withdrawal penalty.
For 401(k)s, an article in Kiplinger's "Borrowing From Your 401(K) to Finance a Home" points out the following scenario where someone barrows from their 401(k):
“Even though you're paying yourself back, the loss of earnings growth could leave a gap in your nest egg. Suppose you borrow $50,000 from your 401(k), repay it at 4.5% interest over five years and retire in 35 years. If the average rate of return on your investments is 8%, the loan will reduce your retirement savings by $50,000…
The dent will be even deeper if you suspend or reduce contributions to your 401(k) while you're paying off the loan. And the tax code doesn't work in your favor: You repay the loan with after-tax dollars, and you'll pay taxes on that money again when you take withdrawals in retirement.”
Forget a 20% down payment. What about a 5% vs 10% down payment?
Outside of losing retirement money, how much does the extra down payment actually benefit you? Using our NewCastle Home Loan Calculator, let's compare the 5% down payment verse 10% down payment scenario for a single family home. See the chart below. The monthly savings is only $79 by putting 10% down. By taking a loan out of your retirement savings to make a bigger down payment, you are missing the point by focusing on this number. You should focus on the above example of your 401(k) account being $50,000 lower at retirement.
You're taking long-term risks for little gain to no gain.
At first, the decision can be compared to looking at an iceberg. However, when you see what is under the tip of the iceberg, you will realize the negative potential consequences with long term risks and opportunity costs. When you're younger, it’s optimal to maximize your 401(k) yearly contributions. At a minimum, contribute the minimal to at least get the "free money" employer match. This money will grow tax deferred until RMD (Required Minimum Distribution) time. That means you are not taxed on this money until you take it out starting around age 70.5 years old. Also, 401(k) contributions effectively reduce both your adjusted gross income (AGI) and modified adjusted gross income (MAGI). If you are not able to contribute to your 401(k), you might be put in a higher tax bracket due to being locked out with a loan on your 401(k).
For an IRA, it's the same deal. You're losing retirement money and now owe more taxes along with penalty fees. You're out more money than when you started with limited to no advantage when you miss the 60-day window.
Borrowing from your retirement savings should not be your first option.
Your personal retirement savings account is easy to tap into, but the borrowers should not take from Peter to pay Paul. It’s a slippery slope once you start dipping into your retirements funds, especially at an early age. This can become an addictive habit. Your IRA or 401(k) should be a lock box that’s not touched until retirement years.
So, would it be better to take money from your retirement savings and put more money down on a home? We're not fans of the idea. But hey, it’s your money. Give it the ‘ole Chevy Chase punch in the nose at Wally World. Just as long as you are aware of some of the consequences.
Note: This article is not to be used as 401(k), IRA, tax, or investment advice. Please consult your investment financial advisor, plan sponsor, and/or tax attorney. It is strictly an opinion of the author.