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Pros and Cons of Withdrawing Money from Retirement Savings

Karen Gibbs

Karen, what are your thoughts on withdrawing money from my retirement savings for a down payment on a home?

- Jack, Glen Burnie

Home for saleJack, I’m not a big fan of raiding your retirement fund.  Most Americans are woefully unprepared financially for retirement and living on social security alone is living in poverty.  By raiding your retirement, you’re borrowing from your future to pay for your current lifestyle.  You lose tax-deferred earnings and miss out on the magic of compounding.

That being said, I understand that emergencies arise.  The government understands that as well and will allow an exception for first time home buyers.  You can withdraw up to $10,000 over your lifetime without penalty for a down payment on your first home (or if you haven’t owned a home in more than 2 years), even if you’re not 59-1/2.

You didn’t tell me what type of retirement plan you have, so I’ll list some pros and cons of the most popular retirement vehicles.

The Roth IRA has the least financial impact, but you must meet certain requirements to be eligible.  You can withdraw after-tax funds you contributed without taxes or penalties if the account has been open for at least five years.  The $10,000 lifetime limit still holds and you must close on your new home within 120 to avoid paying a penalty.  If part of that $10,000 you withdraw comes from interest, you’ll have to pay taxes on that.

Traditional IRAs have the same $10,000 lifetime exception, but as your contributions here are pre-tax, you will have to pay regular income tax rates.  If you don’t close on your home in the 120-day window, you may pay a penalty as well.

The IRS allows for a “hardship” withdrawal from your 401k of up to the $10,000 lifetime limit, but will charge you ordinary income tax rate plus a 10% penalty – all to discourage you from tapping your retirement savings.  You also won’t be able to contribute to your 401k plan for six months.

There is another way to go about getting the down payment, if your employer allows; you can borrow from your 401k plan.You can borrow up to $50,000 or ½ of the value of your 401k but you must pay it back (with interest) to yourself in 5 years.  If you become unemployed, that loan must be repaid within 60 day or be subject to penalty and taxes.

The advantage of borrowing is that you’re borrowing from yourself; you don’t have to go through a credit check.  Interest on your loan is reasonable, usually the prime rate plus two percentage points.  The downside is that you’re using after-tax dollars to repay yourself, yet will pay ordinary income taxes once again when you start taking your money for your retirement.

If you can’t wait and save up the down payment (or rent with an option to buy), borrowing from your 401k may be an option.  Use this calculator to get you started.

Be realistic on how much home you can afford, so that you’re not cash poor when you move in.  Consider all the costs that go along with buying a home, not just the down payment and closing costs.

Lastly, have a plan in place to rebuild your 401k.  Keep making your regular monthly contribution as well as repaying your loan.  Doing so will keep you on the path to financial independence.  


Good luck!

- Karen

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