With home prices at an all-time high and interest rates surging, does it make sense to withdraw money from your retirement savings to buy your next house? According to a new survey by the nonprofit Transamerica Center for Retirement Studies (TCRS) in collaboration with the Transamerica Institute, it appears many people are already exercising this option.
The survey reported that nearly 4 in 10 (37%) of workers have taken a loan, early withdrawal, and/or hardship withdrawal from their 401(k), IRA, or similar plan. Though the reasons vary from unemployment to credit card debt, home buying was also a top-ranking factor.
From a certain perspective (especially of someone who is young and in their 20s), retirement can seem like a far-off, distant goal. They may see that money as sitting around “doing nothing”. So why not put it to use on something I need right now?
The danger in that line of thinking is that there can be many issues with raiding your retirement accounts prematurely. Here’s what you’ll need to know.
Why You Shouldn’t Use Your Retirement Savings
There are many reasons why you’ll want to think twice before making any withdrawals from a retirement account like your 401(k) and IRA.
Taxes
First things first, traditional retirement accounts are given special tax privileges by the IRS. When you contribute to them, those earnings are deducted from your taxable income for the year. Therefore, by withdrawing from your retirement accounts, that money will no longer be protected and you’ll have to pay taxes on it.
For example, consider what would happen if you withdrew $100,000 from your 401(k) to put towards the down payment on a home. If you’re in the 22% tax bracket, then you’d suddenly owe $22,000 in taxes to the IRS. So effectively you’d only be netting $78,000 by making this move.
10 Percent Early Withdrawal Penalty
Taxes aren’t the only thing you’ll have to pay for making an early withdrawal. Anytime you take money out of a traditional retirement account before the age of 59-½, the IRS imposes a 10% early withdrawal penalty. This penalty is in place to discourage account owners from tapping their retirement accounts prematurely.
Continuing with our example from earlier, that $100,000 withdrawal would trigger a flat $10,000 penalty that you’d owe to the IRS. So now your net credit has been reduced from $78,000 to $68,000.
Missed Compound Growth
Taxes and penalties aside, the biggest detriment to taking any money out of your retirement accounts early is the missed opportunity for compound growth.
Compound growth is when earnings are generated on top of your contributions plus any previously accumulated earnings. Generally speaking, the longer your money is invested, the greater it may grow thanks to the effects of compound growth. It’s how many working people retire as millionaires even though they’ve only contributed a fraction of that money throughout their careers.
Just like a seed needs to be in the ground before it can grow into a tree, there needs to be money in your account before compound growth can flourish. Therefore, the more money you take out prematurely, the less growth you can expect. This can have a major crippling effect on the long-term outcome of your nest egg and its ability to successfully provide for you later on in life.
Options for Using Retirement Savings
Even with these warnings in place, many people will still look to their retirement savings for help when buying a home because they feel as though they have no other choice. In that case, here are a few smart options to utilize if this is your only alternative.
IRA First-Time Buyer Withdrawal
If you’re a first-time home buyer, then the IRS will let you withdraw up to $10,000 from your traditional IRA penalty-free. If you’re married, then you can both make a withdrawal which doubles the amount to $20,000 in total.
The main caveat is that you must close on your home loan within 120 days of receiving the funds. Otherwise, it will not qualify.
Even though this withdrawal will be exempt from the 10% penalty, you’ll still owe taxes. Plus you’ll be stifling the compound growth ability of your portfolio.
401(k) Loan
Whether you’re a first-time home buyer or not, another alternative you can utilize is to borrow against your 401(k) balance. According to the IRS, the maximum amount that you may loan yourself is 50% of your vested account balance, or $50,000, whichever is less. In other words, if your balance is $50,000, then you can lend yourself up to $25,000.
What’s nice about borrowing against your 401(k) is that it’s a loan and not a withdrawal. Because of that small characterization, you do not owe any taxes or have to pay the 10% penalty. You do, however, have to agree to pay yourself back within 5 years with interest. Some plans even allow for a longer payback term if the money will be used for the purchase of a primary residence.
On top of that, because you borrow higher amounts, the damage you can do to your nest egg will be greater. Even after paying yourself back, it can be difficult for your nest egg to get back on track for future growth (relative to what it could have been originally).
Roth IRA Contributions
One more avenue you could use is to make a withdrawal from your Roth IRA. Technically since Roth IRA contributions have already been taxed, you can take the money back out any time you want.
The same, however, does not apply to any earnings you’ve accumulated in your Roth IRA account. Earnings must stay within the account until age 59-½ in order to make them tax-free.
For instance, if you’ve contributed $10,000 and the balance has grown to $12,000, then you can only take out the original $10,000. The remaining $2,000 would need to stay behind or face taxes and the 10% penalty.
Consider the Consequences First
It’s easy to see why someone may want to raid their retirement accounts when looking to buy a house. However, given the issues above, it’s important to think about the impact it may have on your current tax situation and future earnings.
While taking out a loan with a high-interest rate might seem like a bad idea now, keep in mind that you’ll always have the opportunity to refinance in the future if interest rates ever go back down. If you look at lending APRs throughout the last 50 years, you’ll see that they’re cyclical (like the economy). Therefore, have a little patience and you’ll most likely be able to get a new loan with a better rate.
In the meantime, try to save up as much as you can for a house using good old-fashioned practices like budgeting your money. If you’re not doing so already, try using a helpful app like Buxfer to monitor your spending habits and determine where some tightening is necessary.
Before every purchase, ask yourself: Do I want this thing more than a home? Before long you’ll be amazed at how many fewer items you’re buying and how much more you’re saving towards your ultimate goal of being a homeowner without raiding your retirement savings.
Featured image credit: Pexels
Buxfer Blog 