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Personal Finance

Should You Tap Your Retirement Account to Buy a Home?

We run down the taxes, penalties, and other risks of using retirement assets for a home purchase.

A soaring stock market (until very recently, that is). Low mortgage interest rates. A booming housing market.

Given that convergence, is it any wonder some prospective homebuyers are wondering if they should tap their retirement accounts to help raise their home down payments? Elevated retirement account balances are likely to be especially tempting sources of cash for first-time buyers who need down payments, since they won’t have home-sale proceeds to apply to their new purchases. The tax code also makes special provisions for some types of retirement-portfolio withdrawals to pay for first-time home purchases.

In an ideal world you'd fund a home purchase with non-retirement assets--money held in a taxable brokerage account, for example. Raiding a retirement account to pay for a home could even be considered a red flag that you’re buying more home than you can afford. As consumer advocate Clark Howard recently pointed out, the home down payment is just the tip of the iceberg in housing-related outlays for homeowners. After signing on the dotted line (and signing again, and again), home-improvement, repair, and maintenance expenses are sure to follow. If putting together a down payment is a strain, you may well be better off waiting until your budget has more padding to buy a home. Yes, rising interest rates are threatening, but rising rates often keep a lid on home prices because they tend to depress demand.

If you've decided to tap a portion of your retirement account to help boost your down payment, know that some ways of doing so will be better than others. Here’s a rundown of them by account type, ranked from the least bad to very worst options.

Roth IRA

A Roth IRA is mainly a retirement savings vehicle. But if you need extra for a home down payment, a Roth IRA should be your first stop. That's because you can withdraw your own contributions (no investment earnings) for any reason without incurring taxes or penalties. You already paid taxes on those contributions, so if you’re withdrawing them you won’t need to pay taxes again.

Withdrawing the investment earnings component of a Roth IRA carries more strictures than withdrawing your contributions, and that's especially true if you're younger than 59 1/2. However, if you've had the money in the Roth IRA for five years or more but you're not yet 59 1/2, you can tap the investment-gain piece of the Roth IRA without penalties or taxes under certain circumstances, including if you're making a first-time home purchase. Note that just $10,000 can be withdrawn tax- and penalty-free for a first-time home buy, however.

If your Roth IRA is less than five years old, you can circumvent the 10% penalty on a withdrawal of up to $10,000 of investment earnings, provided you're a first-time homebuyer, but you'll owe taxes on that amount because five years haven't yet elapsed. Thus, for someone in the 25% tax bracket, a $10,000 withdrawal of investment earnings could shrivel to just $7,500 once the tax effects are factored in.

Traditional IRA Withdrawals

As with Roth IRA withdrawals, withdrawals of traditional IRA assets before 59 1/2 can avoid the 10% early withdrawal penalty if the assets are used for a first-time home purchase, up to $10,000. Yet traditional IRA assets are still less attractive than Roth IRA assets in this instance, because they're apt to be subject to income taxes unless the account owner is older than 59 1/2. Just how much tax depends on the ratio of assets in the account that have never been taxed (deductible contributions and investment earnings) to those that have been taxed (nondeductible contributions).

For investors whose IRAs consist entirely of deductible contributions, rollover assets from former employers' 401(k) plans, and investment earnings, the distribution would be 100% taxable at the investor's ordinary income tax rates. On the other hand, if the traditional IRA were a blend of already-taxed money (nondeductible contributions) and already-taxed assets, the taxation would depend on the ratio between the two. If an account consisted of 70% deductible contributions/investment earnings and the rest nondeductible contributions, the withdrawal would be 70% taxable.

401(k) Loans

There are two avenues for tapping 401(k)s: loans and withdrawals. The first and better option--though far from ideal--is a 401(k) loan. On the plus side, you pay the interest on the loan back into your 401(k) account rather than to a bank. The loan limit is typically the lesser of $50,000 or 50% of your vested account balance, providing an opportunity to meaningfully augment a down payment.

However, borrowing against a 401(k) for a home purchase is dicey on a couple of levels. First, five years is a typical term for a 401(k) loan; if you borrow a sizable amount, the repayment amounts could strain your budget because you’ll have to service both the 401(k) loan and the loan on your new mortgage could present a financial hardship. Having a 401(k) loan outstanding may also affect how much you'll be able to borrow from the bank for your loan. Finally, there's the worst-case scenario--if you lose your job, you could have to pay back the full amount that you borrowed from your 401(k) plan within 60 to 90 days. If you can't pay it back, the withdrawal will count as an early distribution and be subject to ordinary income tax as well as a 10% penalty.

401(k) Withdrawals

In contrast with IRA withdrawals, which exempt $10,000 for first-time home purchases from the 10% penalty for investors younger than 59 1/2, 401(k)s and other company retirement plans offer no such exemption for homeownership. 401(k) owners may be able to crack into their money to make a first-time home purchase, but it would be subject to the 10% penalty as well as ordinary income tax. For investors in the 25% income tax bracket, an early 401(k) withdrawal of $25,000 would drop to just $16,250 once penalties and taxes are factored in. In other words, avoid a 401(k) withdrawal at all costs prior to retirement.

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