Should we use some of our retirement funds for buying our new home?

Question of the week:  Should we use some of our retirement funds for buying our new home?

Answer: This is a recurring question that we cover every few years in the WR&MU. With home prices rising and rates at historic lows, many families are looking to purchase homes, but are in need of more funds for closing than they may have saved. At least saved in traditional savings accounts; but when they look at their employer sponsored retirement account, i.e. a 401(k) account, or other retirement account such as a rollover or SEP IRA they see they have funds that could make a home purchase possible.

First, I am not an accountant, CPA or tax advisor, it is recommended you consult with one before entering any transaction that may have tax ramifications for you in the short or long terms. That said, the IRS website also has a lot of information on retirement funds and their use for purchasing homes.

Most contributions to retirement accounts are made pre-tax, meaning the amount you contribute to your retirement account is not counted as taxable income. Because of this, when you withdraw funds from an account to which pre-tax contributions the amount you withdraw is taxed as ordinary income. For instance, if you access $25,000 from your IRA that amount will be added to your other income for that year when calculating the amount of money you owe for federal and state income taxes.

Note that if you are under 59 ½ when you withdraw the funds there will also be a 10% penalty for early withdrawal from the account.

However, the IRS allows individuals under 59 ½ to withdraw up to $10,000 in their lifetime for the purchase of their first home (defined by the IRS as “no present interest in a main home during the two-year period ending on the date of the acquisition of the home which the distribution is being used to buy, build, or rebuild.” In short if you are closing escrow today, October 30, 2020 and you sold your prior home on October 29, 2018, the IRS considers you a first-time home buyer.

If you are under 59 ½ and take $10,000 out of your IRA to purchase your first home you will still be taxed on the amount as ordinary income. If are married and your spouse has an IRA, s/he can also take out up to $10,000 for the purchase without penalty, provide s/he also qualifies as a first-time buyer.

Another option for using retirement funds for purchasing a home is as a “bridge” between the purchase of your new home and the sale of your existing home. This option has some risk which I will detail below.

Here is the scenario. You are purchasing a new home for $700,000 and want a loan for $490,000, which requires $210,000 down payment. You currently have $150,000 in savings and investments you can use for the down payment, the balance of the funds for closing are going to come from the sale of your existing home. After your home sells you are expecting to net approximately $150,000.

The two transactions are supposed to close simultaneously, so the proceeds from your sale will be transferred to the escrow account on your purchase transaction. A few weeks into your sale transaction an issue comes up with the buyer that will prevent them from obtaining loan approval, such as losing their job. You had several offers on your home and another buyer is able to open escrow right away but will not be able to close until twenty to twenty-five days after the escrow on your new home is supposed to close. The couple selling you their home have also purchased another home and need to close on time.

In a rollover-IRA from previous job, you have $200,000. The IRS regulations pull funds from a qualified retirement account and pay no taxes or penalties as long as all the funds withdrawn are placed back in the account within 60 days.

Because of this regulation, you pull $60,000 out of your retirement account and close the escrow on your new home. Twenty-five days later the escrow closes on the home you are selling, you receive proceeds of $150,000 and deposit $60,000 back into your retirement account.

There is a big risk in this type of transaction. That risk is the 60-day limit. What if the new buyer of your home also has issues and cannot close? You get another buyer but by the time the home closes and you get your funds your deposit is in the account 62 days after you made your withdrawal? If this happens then the $60,000 is taxes as ordinary income, and if you are under 59 ½ there is the added 10% penalty. Keep in mind, that this $60,000 may put you in a higher tax bracket so the funds may be taxed at a higher rate than you would other wise pay.

If you are considering this tactic for your real estate transaction you need to make very sure that you will be able to meet the 60-day time frame for re-depositing funds.

The most common use of retirement funds for purchasing a home is accessing funds from an employer sponsored 401(k) or 403(b) retirement program (moving forward I will just use 401(k) and it will represent both account types). One option is to withdraw the funds you want to use for you home purchase. If you do this, as with withdrawals described above, you will be subject to income taxes on the funds, and possibly a 10% early withdrawal penalty.

Most homebuyers who are using funds from their 401(k) accounts to purchase a home borrow the funds from their account. Almost all such accounts allow employees to borrow from their accounts for medical, educational or home purchase needs. The maximum amount that can be borrowed is either 50% of the balance in the account or $50,000, which ever is lower.

Different plans have different rules and policies for borrowing funds, and for how the funds will be repaid. Typically, the minimum loan period is 5-years, although for home purchases many plans will enable a longer repayment period, some up to 30-years.

If you are going to borrow from your 401(k) to purchase your new home you must be aware that there is some tax risk involved. If you have failed to repay the loan before your employment is terminated, either voluntarily or involuntarily, then the amount remaining on the loan is taxed as ordinary income, and if you were under 59 ½ when you accessed the funds the 10% penalty will apply. The same may hold true if you company is acquired by another company and your 401(k) is transferred to the new employer’s retirement plan.

If you do borrow from your 401(k) the loan repayment is automatically deducted from your pay each pay period. Note that the repayment amount is after taxes, meaning you pay taxes on the amount of the loan payments; it is the same as if you receive your net pay and then write a check to pay the 401(k) loan payment.

The primary argument made against borrowing from your 401(k) for the purchase of a home is that when you take the loan the funds come out of the investments in your account, therefore you lose the growth those funds would receive as the markets grow. This is true, if you borrow $25,000 to purchase your new home and over the next five years it takes you to repay the loan the market has increased 7%, you will have missed out on $1750 in growth. However….

Like all loans, the 401(k) loan has interest that you must pay. There are different rate structures from plan to plan, but they fall into two categories, a rate tied to the Prime rate, so it adjusts when the Prime rate changes, or a fixed rate of return. Let’s say your plan has a fixed rate on your 401(k) loan of 4%. That 4% interest you pay is to yourself. So, if you have a 5 year repayment you will pay yourself $27,625, a gain of $2,625. Even if the market grows at a much higher rate over time, you are still making a return on the funds you borrowed and putting them into your retirement account.

Every situation and circumstance is different and when considering utilizing retirement funds to purchase a home there are many factors to consider. Among these factors is how strong is your retirement planning and accounting? Are you making, and will you continue to make, contributions to your retirement accounts? How close are you to retirement? Are you anticipating your income to increase in the future so you can increase your contributions to your retirement accounts, if so for how long?

As a rule, I am more opposed to a straight withdrawal of funds for the purchase of your new home than I borrowing funds from your retirement accounts, primarily due to the tax implications and the return you will pay into your account if you borrow the funds.

Many advisors are against considering using retirement accounts for a home purchase, even with the use of a loan, as they are laser-focused on how much money you will have available when your retire, and taking funds out of an account can decrease the amount of funds to pay for your needs in retirement.

The biggest factor I see in leveraging your retirement accounts for the purchase of your new home is you have the ability to fix the cost of your housing for a long time. The biggest expense most of us will have in retirement will be housing, unless our home is free and clear of any mortgages. If you are renting not only will you always have a relatively high expense compared to other needs, but it will be increasing through the years.

When you purchase your home you have many, many long term advantages. You fix your main housing cost, exceptions being taxes, insurance, etc. You build equity, often faster than any returns in investment markets. In the future with the equity you have built you can sell and down size to a smaller home and lower, or eliminate, your mortgage expense. Or perhaps you have enough equity to be able to obtain a reverse mortgage which can eliminate a mortgage payment and possibly provide a monthly payment to pay for other necessities.

Most Americans will retire with inadequate funds in retirement accounts to supplement whatever assistance may be available to them through social security or other retirement payments from pensions. Those who own homes will be far better off than those who do not. Those who own homes and have funds in retirements accounts will fair even better.

The decision to access retirement funds to purchase a home need not be an “either-or” decision, but if it is, depending on where you are in life, my preference is home ownership.

If you are considering purchasing a home and want to discuss the options you have available please contact me.

Have a question? Ask me!

Lots of economic news this week. Let’s start with the big headline, the economy grew at a rate of 33.1% in the 3rd quarter after shrinking 31.4% in the second quarter. A lot of the growth was a result of the trillions of dollars shoved into the economy from Washington in the form of direct payments to tax payers, increased payments for unemployed workers and PPP loans to businesses. This enable consumer spending to continue and help reverse the economic crash in the spring. Technically, the increase in GDP in the 3rd quarter after negative GDP in the first two quarters ended the recession (defined as two consecutive quarters, or more, of negative GDP). Realistically, we are not out of the economic slump woods.

Also reported this week, were continued increases in personal incomes, up 0.9%, and consumer spending, up 1.4%, in September from August. With the elimination of the unemployment supplement in August, the increase in income and spending is a bit of a surprise.

Rates for Friday October 30, 2020: Markets continue to bounce around on political news, expectations for more stimulus and most importantly expectations for the economy. The GDP and other economic news was shrugged off by investors in mortgage and bonds, normally the news this week would push rates higher, as the anticipation is increasing cases of Covid-19 as we move into winter and the unknown aspects of how impactful that will be on hospitals and workers. The yields for those purchasing Mortgage Backed Securities are lower than they have ever been, below 2%, which is barely above inflation, except the funds are locked in for thirty years and inflation is not.

Please note rates are for purchase transactions, refinance rates are higher, please call for quotes to meet your situation.

FIXED RATE MORTGAGES AT COST OF 1.25 POINTS LOCKED FOR 45 DAYS FOR PURCHASE TRANSACTIONS:

30 year conforming                                         2.625%   Flat

30 year high-balance conforming                2.875%    Flat

Please note that these are base rates and adjustments may be added for condominiums, refinances, credit scores, loan to value, no impound account and period rate is locked. Rates are based on 20% down with 740 FICO score for purchase mortgages.

It’s the kids. It’s the kids I feel the saddest for through the pandemic. Missing school, missing friends on playgrounds, or in many cases at each other’s homes. No recess, sports leagues, dance classes or letting grandma spoil them with a quick milkshake run on Saturday.

Today they should be having Halloween parades through the classrooms of their schools in their clever costumes. Tomorrow they should be ringing our doorbells as Princesses, Intergalactic Heroes, cartoon characters or scary monsters.

As much as they like the candy, many of the kids just like being noticed for their costumes, especially if homemade. I always get more smiles for complimenting Cinderella on how beautiful she is, or feigning concern at how scare the Zombie is, than the ubiquitous tossing of some candy into their bag or plastic pumpkin.

When we have a viable vaccine, my vote is that we give it to school kids and in-school personnel first. Let them get back in all the classrooms, let them learn, play and grow mentally and socially as soon as possible.

Happy Halloween, I hope you are able to work something out in your neighborhood so the little ones feel special.

Have a great week,

Dennis

Past Weekly Rate & Market Updates can be found on my blog page at my website www.DennisCSmith.com/my-blog