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Be Cautious About Raiding Roth IRA to Buy a Home

When interest rates are low, a bigger mortgage makes more sense. Some lending programs also allow smaller down payments.
Mortgage Rates Today, Monday, Oct. 24: Another Small Decrease; Home Values Rising

The long stretch of rock-bottom interest rates might come to a close soon.

In the mortgage market, that means buyers who haven’t yet jumped into homeownership are facing what may be their last chance to do so at rates below 4%. And though there’s no real urgency — when the Federal Reserve does start raising rates, the increases will be small and gradual — some might consider digging into their retirement funds to make the leap.

Withdrawals of Roth IRA contributions — for any reason — are tax- and penalty-free, making them attractive as a home down payment. But is raiding your retirement to fund your home purchase a good idea? Here are some things you should consider.

Contributions versus earnings

Roth IRA contributions can be pulled out tax-free at any time; after all, you’ve already paid taxes on that money. The rules from the IRS can be tricky, though. The agency specifies contributions rather than earnings, but your Roth IRA account provider might not clearly spell out the difference.

You may be able to tap your Roth IRA contributions plus $10,000 of earnings per spouse.

It helps to keep track of your contributions as you make them. If you haven’t done that, you can dig up IRS Form 5498, which is what the IRA provider uses to report contributions to the IRS. You should be able to locate that within your account information online (most brokerages will keep seven to 10 years’ worth of documentation available). If you can’t, call and ask for copies.

You can also tap the earnings from your Roth IRA investments, but these are subject to more restrictions under the Roth IRA withdrawal rules. If the account is at least five years old, you’re allowed to put up to $10,000 in earnings from your Roth IRA toward a first-time home purchase, without tax or penalty, as long as it is used within 120 days of withdrawal. (You’re also allowed to use that amount from a traditional IRA, with no account age requirement, though you will pay taxes on the distribution from that type of account. See traditional IRA withdrawal rules.)

Combine your contributions with $10,000 of earnings, and you could have access to a considerable amount of money — especially if you and your spouse both have a Roth IRA, because these rules apply to each of you.

(Learn more about Roths in our Roth IRA explainer.)

Who qualifies as a first-time homebuyer?

The IRS defines a first-time home purchase very loosely; it doesn’t actually have to be your first home at all. You’re considered a first-time homebuyer under these early distribution rules for Roth IRA earnings if you or your spouse have not owned a principal residence in the last two years.

The IRS also allows these distributions to be used for a first-time home purchase made by a spouse, child, parent or grandparent.

Loss of tax-free growth

The first-time homebuyer exception lets you avoid paying taxes on the earnings, but removing that money has implications beyond just taxes.

Taking out $10,000 for a down payment doesn’t seem like much, but the opportunity cost can be much greater.

One of the benefits of a Roth IRA is that because money is contributed after-tax, distributions in retirement are not taxable. So if you open a Roth in your 20s and allow those contributions to grow with investment income over 40 or 50 years, you’re accumulating a great deal of money — money you’ll never have to pay taxes on, if distributions are taken according to IRS rules.

Taking out $10,000 for a down payment doesn’t seem like much, but the “opportunity cost” is surprising: Left invested over 40 years, that $10,000 could turn into nearly $150,000 with a 7% annual return. And in a Roth IRA, that’s $150,000 tax-free. (Double that, by the way, if you and your spouse both take this route.)

A bigger mortgage makes better sense

When interest rates are low, financing more of your home isn’t necessarily a bad thing  — plus, mortgage interest is tax-deductible.

“If your mortgage interest rate is less than 5% per year, then take the largest mortgage possible, and pay it down as slowly as possible,” says Jarrett B. Topel, a certified financial planner with Topel & DiStasi Wealth Management in Berkeley, California.

That argues against borrowing from your retirement to help finance your home purchase.

“When money is cheap — as it is now — you want to borrow for the long term and leave your money invested in the Roth IRA,” Topel says. “Roth IRAs are designed for retirement savings. You can get a loan now for your home, but you will not be able to get a loan later for your retirement.”

There are other options

There are ways to buy a home that don’t involve raiding your retirement account. For one, consider programs for first-time homebuyers that allow smaller down payments, For instance, the FHA loan program requires as little as 3.5% down (though you’ll still pay mortgage insurance, which protects the lender when buyers don’t put at least 20% down).

If you have to draw from retirement savings to buy a home, you could be setting yourself up for trouble.

If the goal is to avoid mortgage insurance — and that’s a good aim, because the coverage can be costly — you will want to shoot for 20% down. But you can build that down payment slowly over time, even scaling back contributions to retirement accounts while you do. Temporarily cutting back contributions is, in many cases, a better option than pulling money out.

Finally, remember that if you have to draw from retirement savings and empty bank accounts to buy a home, you could be setting yourself up for trouble. Understand how much home you can afford, and don’t overextend. You don’t want to walk into a home drained of all available cash. As any current homeowner will tell you, maintenance issues will pop up — always, it seems, right after you close the deal.

Arielle O’Shea is a staff writer at NerdWallet, a personal finance website. Email: Twitter: @arioshea.

Image via iStock.