Disclaimer: Listen, it wouldn’t be prudent for us to start this article without a HEAVY warning. Using your 401K or IRA for the down payment of your house is not a circumstance that should be frequently used or considered. Doing this could benefit a very niche group of people in specific circumstances (that you must decide for yourself), but for the large majority of people, please look at your existing finances first before contemplating this as an option; the costs are high, as well as the risk. Phew, now with that out of the way, let’s get started.
So you want to tap into your “untouchable” money.
We’re going to give you a couple rules to follow before you can answer this question for yourself. But first, a cookie metaphor: your retirement money is like a cookie. Hear me out, I promise. Now, cookies have a specific set of ingredients–in this case, the only ingredient is your cold, hard, tax-free cash. It must be baked for the proper duration (until you’re 60ish), at just the right temperature (hello 401k matching!), and you should ideally not open the oven while it cooks, or the cookies could fall flat. AND THIS IS WHAT YOU’RE TRYING TO DO RIGHT NOW. I want that to be clear. You are trying to eat your cookies before they are cookies. You could get salmonella, or end up eating a wet, goopy, dough-y mess.
The #1 problem for taking money out of your retirement accounts, is even if you take out the “dough” prematurely, you are often required to put it back into the account. Repayment options vary, but expect interest, and you will have to pay it out of your already taxed income.
Does it matter which I withdraw from?
The primary difference between 401ks and IRAs is who sponsors it. A 401k is employer sponsored, and an IRA bank/broker sponsored. With two separate entities controlling the accounts, they obviously have different rules for withdrawal of any funds prematurely. These are going to differ for every single person and for every situation, so we want to provide some general guidelines.
Rule #1: Please don’t touch it. I’m serious! This money is for you, when you’re ancient and decrepit and can’t work and you don’t have anyone who will let you ride on their coattails. This is a safety plan for your geriatric self, try to respect that and find money another way.
Rule #2: If you must take out some money, make it small, and start with your IRA’s. These can be specially equipped to assist first-time home buyers, so long as your withdrawal amount stays below $10k, it can be withdrawn tax-free and without penalty, (though it does get reported to your federal and state taxes as income and could bump you up in a tax bracket which might bite you later). If we’re being honest, in today’s economy, $10,000 is scarce enough for your 3% down payment, so it would only be beneficial if it’s in addition to existing savings that you have prepared for your down payment that would eliminate the need for a jumbo mortgage or PMI–both of which still may be better alternatives depending on the total payments.
Remember: Your retirement accounts are meant to sit untouched and grow with interest. This is how they produce the best options for you. Taking from them prematurely is robbing future you, to pay current you. “Current” you needs to have a bit more sympathy for old, gray-haired, feeble you.
Rule #3: Try a loan from your 401k, before just a straight-up withdrawal. Your employer will have different rules, but you can take a loan from your “future” self, specifically for your primary residence and can sometimes waive any upfront fees or taxes with the only stipulation being repayment.
Tip: If you can repay this quickly, but need a quick influx of cash, this may be the right choice for you, depending on your loan length and interest required.
Rule #4: If you must take a withdrawal from your 401k, be prepared for fees and taxes and repayment options that are not friendly. Again, you must check with your employer and see if this is even allowed, and read the fine print to know what the rules for withdrawal are. Can you still contribute to your account with a withdrawal pending repayment? If you cannot, this is a very risky play that could set you back several years in growth for your retirement accounts.
Why do you want to take out money?
If you’re thinking of using it because you’re short on cash for earnest money, escrow, or at the closing, there are better alternatives.
Your earnest money can come from any financial source you have and isn’t tracked like down payment income. So you could borrow from a friend, use your credit card as a cash advance (Please also don’t do this), or take out a personal loan. All of these are more preferable.
Money for escrow typically has to come the same way as a down payment, it’s monitored very closely because the bank needs to ensure that your finances are stable. Withdrawing from your retirement accounts prematurely is still a loan (in some cases), and must be repaid, which adds to your total debt which is the primary contributor to mortgage lenders qualifying you for a loan. It could also jeopardize your loan approval. Truthfully, most banks will wrap closing costs into the life of the loan.
Also, as much as mortgage insurance sucks, PMI is preferable to having to pay interest and a withdrawal fee and repay yourself (but this time with already taxed income) and all the other shenanigans that we listed above in order to tap into your retirement accounts. If you can, leave those alone to grow for you quietly, and only tap in when necessary.
Key Questions to ask yourself before using your retirement accounts
How soon will you be able to repay?
What are your repayment interest rates?
Do you qualify for first time home buyer benefits?
Will your house appraise at a higher rate than your fees and interest for repayment? (This is always going to be a gamble, but you can track annual growth and get a good idea.)
Can you still contribute to your 401k while repaying the amount you’ve already withdrawn? (This of course will impact your 401k future growth.)
Your current tax bracket will likely be higher now, than in the future when you withdraw so you’re losing more money than by letting it grow due to repayment.