July 16, 2018
July 16, 2018
Since so many people have most or even all of their savings in a retirement plan, it can be tempting to tap it for a down payment. But before you do, consider both the cost of liquidating retirement funds, as well as the options that you have to avoid it.
With most retirement plans, any funds that you withdraw from the plan will be subject to ordinary income tax. The tax will be due in the year that the funds are withdrawn from your account. That means that if you withdraw $10,000, and you’re in a combined marginal tax bracket of 20% for both federal and state income taxes, you will have to pay $2,000 in tax on the amount of the withdrawal.
But that’s not all.
If you’re under age 59 ½, the withdrawal will also be subject to a 10% early withdrawal penalty. That means that the cost of withdrawing $10,000 from a retirement plan will rise to $3,000. That’s a seriously expensive way to raise funds for the down payment on the purchase of a home.
You may get a break on a withdrawal from an IRA, at least regarding the 10% penalty. You can withdraw up to $10,000 from an IRA for the first time purchase of a home. But that waiver isn’t available to other types of retirement plans, like a 401(k).
What are some less costly alternatives to coming up with down payment money?
It’s often assumed that you must make a down payment of 20% on the purchase of a home. But while that is the preferred size of a down payment, it’s certainly not required. Under most mortgage programs, you can make much lower down payments.
For example, conventional mortgages have down payments as low as 3% of the purchase price. The FHA down payment requirement is just 3.5% of the purchase price. And VA mortgages don’t require any down payment at all.
If you’d rather not take money out of your retirement fund, you can also get a gift from a family member. There are different gift rules for different mortgage programs. But if you use an FHA mortgage, the entire down payment can be comprised of a gift.
And while conventional mortgages typically require that you put down at least 3% or 5% of the purchase price from your funds, you can use entirely gift funds if the down payment and gift will be 20% or more of the purchase price.
Rather than withdrawing money from a retirement plan, you can instead take a loan against the plan. Under IRS rules, you can borrow up to 50% of the vested balance in your retirement plan, up to as much as $50,000. This applies to employer-sponsored plans only. IRAs are not eligible for loans.
If you do go the loan route, you should be aware of a few potential complications. For example, since a 401(k) loan is a loan, it will require repayments. These will reduce future contributions to your retirement plan. Payments normally run for up to five years.
Also, only consider borrowing against the plan if you expect to stay with that employer until the loan is fully repaid. Unpaid loan balances become automatic plan distributions if they are not repaid within 60 days of termination. If that happens, you’ll owe both ordinary income tax and even a 10% early withdrawal penalty on the outstanding balance of the loan.
Many homebuyers mistakenly believe that saving money is the only way to come up with a down payment on a house. But you can also sell possessions. If you have enough of them, or if you have one or two that are particularly valuable, they can make up most or all of your down payment.
For example, let’s say that you have a third car, a motorcycle, or even some sort of recreational vehicle. You can sell it, and use the proceeds for the down payment on a home.
If you go this route, just make sure that you have a paper trail. That means getting a bill of sale, a copy of the check in payment from the buyer, and evidence that it was deposited into your bank. A mortgage lender will need all of that documentation to prove that the source of funds was in fact from the sale of the item, and not proceeds from a new loan.
From time to time, local governments offer down payment assistance programs. These can be either a grant or loan. They typically satisfy the down payment requirement for either a conventional or an FHA mortgage.
Check with your first mortgage lender or your real estate agent to see if these programs are available in your area. They come and go, but if you’re looking to buy at a time when a program is available, this can satisfy your down payment requirement.
According to the IRS, the average income tax refund is over $3,000. It can be even higher if you also expect to receive a state income tax refund.
Even though a tax refund may not provide you with the entire amount you need for a down payment, it can represent a substantial chunk. For example, let’s say that you are purchasing a $200,000 home with an FHA mortgage. You will be required come up with a 3.5% down payment, or $7,000.
If your federal income tax refund is $3,000, and your state income tax refund is $500, then you will have half of the down payment that you need from your combined refunds.
That would be an outstanding time to purchase a home!
So before you go liquidating your retirement plan to come up with a down payment on a new home, first consider the alternatives. There are plenty of them, so you probably won’t need a retirement distribution to purchase your dream home. And that will save you a fortune at tax time.