If you're straining to come up with funds for a down payment for your home, you may be tempted to tap one of your retirement accounts. In principle, it's not a good idea, since you'll need those funds for retirement and you could end up paying a heavy tax price. But in certain circumstances, it may be a reasonable approach.

Generally, a straight withdrawal from a pre-tax 401(k) or traditional individual retirement account is a bad idea - it's simply too costly. The distribution will be taxed as ordinary income at federal rates up to 35%, there are state income taxes to fork over, and there's usually a 10% federal penalty too.

Best Cities To Rent And Own

How To Tap Retirement Funds Penalty Free

How To Start Retirement Savings Off Right

But if you're a younger person buying your first home, a modest out-and-out withdrawal from a traditional IRA can make some sense, says Mike Johnson, a principal at St. Louis-based Moneta Group, a financial planning firm. That's because the law allows first-time home buyers to draw up to $10,000 from a traditional IRA account without being hit by the 10% penalty, so long as the funds are used for a home purchase within 120 days. (For more insight, see Avoiding IRS Penalties On Your IRA Assets.)

Since your withdrawal will be taxed, try to time the withdrawal and the home purchase early in the year. That way, you'll maximize the mortgage-interest deductions for the year, offsetting some or all of the extra income. (Remember, any points you pay on the initial mortgage to buy a home are deductible in the first year.) If your purchase falls through, be sure to roll the money back into an IRA within the 120 days to avoid taxes and a penalty.

Another approach that can make sense is withdrawing money from a Roth IRA. The contributions you made to the Roth weren't tax deductible to begin with, and you can withdraw your original contributions (not the earnings) at any time without owing any taxes or penalty. That flexibility is one reason why Roths are a good vehicle for young folks who want to save for retirement, but worry they might need the money for other expenses first. The downside? By depleting your Roth, you're giving up a valuable hedge against future higher tax rates, since all withdrawals from a Roth in retirement are tax free.

What about tapping your 401(k)? In most cases, you'll want to forget about an out-and-out withdrawal and work instead with your employer to arrange to take a loan from your 401(k) account. The law allows you to borrow up to half your vested balance or $50,000, whichever is less, without triggering taxes or a penalty.

If you've already maxed out the amount you can borrow from your 401(k), the law also allows you to take a "hardship" withdrawal from a 401(k) to buy (or keep) a primary home. But you'll be socked with both ordinary taxes and the 10% penalty for this withdrawal, and you'll be barred from contributing to your 401(k) for six months. (Note that while the law allows for both loans and hardship withdrawals, your employer doesn't have to permit either of them and can limit the circumstances in which they're allowed. So, for example, your employer might not consider your desire to buy a home a "hardship.") (To learn more, read Sometimes It Pays To Borrow From Your 401(k).)

Borrowing from your 401(k) isn't like pledging retirement funds as security for a bank loan - you'll really be selling stocks or bonds owned in the account and using the proceeds to fund your loan to yourself. You'll make principal and interest payments back into your 401(k). So where your 401(k) previously owned stocks or bonds, it will now own a fixed-income investment in you. The interest rate is set by your employer, usually at a percentage point or two above the Libor or Prime rate. Normally, loans from a 401(k) must be paid back within five years. But for a home purchase, an employer can agree to a 15-year repayment schedule.

Proceed with caution here: If you leave your job, your employer is likely to demand immediate repayment of the loan. If you can't come up with the cash, it will be treated as a withdrawal, again subject to both ordinary income taxes and (assuming you're young) a 10% early withdrawal penalty.

Financial advisor Shomari Hearn, who runs Palisades Hudson Financial Group's Fort Lauderdale, Fla., office, says a 401(k) loan can make sense. He even arranged one for himself last year. Hearn, 34, had wisely sidestepped Florida's real estate bubble after moving to the state five years ago, opting to live in a rental property. When he and his wife had a daughter, they bought a four-bedroom home in Sunrise, 14 miles west of his office, for $410,000. The same home had sold for $650,000 during the bubble.

To make a 20% down payment, Hearn took $42,000 from his nonretirement savings and borrowed another $40,000 from his 401(k) with a 5.25% interest rate repayable in 15 years. By putting down 20%, he was able to get a 30-year mortgage fixed at 5% and avoid an estimated $160 a month in onerous private mortgage insurance that a 90% loan-to-value mortgage would have burdened him with. Even though the 401(k) loan must be paid off in half the time of his primary mortgage, his total monthly payment on the two loans is still $50 a month lower than the amount Hearn calculates he would have paid with a single, larger mortgage. Plus, the payments he's making to his 401(k) account will end before he has to start paying his daughter's college bills.

Alas, though many large employers are willing to make 15-year loans, smaller employers frequently are not, warns Ronald Stair, a principal at Creative Plan Designs, of East Meadow, N.Y. Stair's firm administers many 401(k) plans for companies that don't wish to administer their plans in house. He's not fond of the extra work and expense the longer-term loans create for the plans, and fewer than one in 20 of his clients will agree to one, says Stair.

Even though the loan he's getting from his 401(k) plan resembles a second mortgage Hearn has no plans to deduct the interest payments he'll be making. (The arrangement Hearn has treats it more as a personal loan, with Hearn not offering up a lien on his home as security.) But if you've got an employer and a primary mortgage lender who are willing to play along, the interest payments from a loan like this can be treated as deductible mortgage interest, says tax accountant William Fleming of PricewaterhouseCoopers in Hartford, Conn.

Fleming notes some additional paperwork will be required to formalize a 401(k) loan as a mortgage. You'd definitely want your 401(k) account to hold a lien on your house and ideally for your plan administrator to issue a 1098 form to you and to the Internal Revenue Service at the end of each year. The additional work pays for itself in tax savings to you.

Again, Stair figures only a lucky few will succeed at getting both their employer and primary mortgage lender to go along. Note that tax rules prohibit a "key employee" of any firm from deducting interest payments on a 401(k) loan from his or her income. And Stair frets that even if a non-key employee is able to arrange the needed paperwork with his or her retirement plan administrator, the deal may complicate negotiations with the primary mortgage lender. The bank may regard the lien held by the 401(k) plan as a threat to its ability to control a foreclosure in case of default. So make sure that your mortgage lender has signed off on this arrangement in advance, to avoid having the loan discovered later and you being declared in default on your mortgage.

For simplicity's sake, you may be better off treating this 15-year loan from your 401(k) as a personal loan and deciding not to deduct the interest on this loan from your income. In Hearn's case, he's convinced he's coming out ahead without the tax deduction. The private mortgage insurance payments he's side-stepping wouldn't have been tax deductible either. (Under a temporary provision due to expire at the end of this year, mortgage insurance payments are deductible. But the deduction begins to phase out when your adjusted gross income exceeds $100,000 and is denied completely above $109,000.)

So focus on all the tax rules, but don't lose sight of what of what's really going on when you shift funds from a retirement account into a down payment. There's an opportunity cost: You're forgoing the potential gains in the stock or bond markets in return for lower mortgage payments and future home appreciation. Even if you believe the potential return on your home purchase is greater than your opportunity cost, be aware of the concentration risk here. After all, you'll be shifting the money from hundreds or thousands of stocks and bonds into a wager on a single home in a single community. If your job security is also tied to the health of that community, you've got even more concentration of risk.

Related Articles
  1. Home & Auto

    Avoiding the 5 Most Common Rent-to-Own Mistakes

    Pitfalls that a prospective tenant-buyer could encounter on the road to purchase – and how not to stumble into them.
  2. Taxes

    What IRS Form 990 Tells About a Nonprofit

    Want a picture of an organization's activities? This annual form, open to the public, sums up everything from salaries paid to missions accomplished.
  3. Retirement

    The 3 Most Common 401k Rollover Mistakes

    No one is born knowing the tax rules for 401(k)s and IRAs, but only dummies, scaredy cats and suckers don't buckle down to learn them.
  4. Home & Auto

    Renting vs. Owning: Which is Better for You?

    Despite the conventional wisdom, renting might make more financial sense than you think.
  5. Taxes

    Top Reasons to File Separately When Married

    Most of the time, it makes sense for couples to file their taxes jointly. Except for these possible exceptions...
  6. Taxes

    What IRS Form 1023 Is Used For

    To be treated as a tax-exempt organization, start by filling out this form.
  7. Taxes

    Late with Your Taxes? Grab IRS Form 4868

    Fill out this form to get a few more months to file your tax return. But remember, April 15 is still the payment due date if you owe taxes.
  8. Investing News

    How Does US Social Security Measure Up Abroad?

    Social Security is a hotly debated topic. After examining the retirement plans of three different countries, the U.S.'s does not come out the winner.
  9. Taxes

    What IRS Form 8949 Is For

    Selling a painting or that lake property? Disposing of your fossil fuel stocks? You need to know about this IRS form.
  10. Investing

    Five Things to Consider Now for Your 401(k)

    If you can’t stand still, when it comes to checking your 401 (k) balance, focus on these 5 steps to help channel your worries in a more productive manner.
  1. Section 1231 Property

    A tax term relating to depreciable business property that has ...
  2. Qualified Longevity Annuity Contract

    A Qualified Longevity Annuity Contract (QLAC) is a deferred annuity ...
  3. Fair Housing Act

    This law (Title VIII of the Civil Rights Act of 1968) forbids ...
  4. Backdoor Roth IRA

    A method that taxpayers can use to place retirement savings in ...
  5. Exchange-Traded Mutual Funds (ETMF)

    Investopedia explains the definition of exchange-traded mutual ...
  6. Construction Loan

    A short-term loan used to finance the building of a home or another ...
  1. Can I take my 401(k) to buy a house?

    Once you reach 59.5, you can use the funds in your 401(k) retirement savings account to buy a house or any other expense ... Read Full Answer >>
  2. What is the tax rate of a Roth IRA if I withdraw it for the purchase of a house?

    It can be tempting to tap your retirement funds to use toward the purchase of a home, and you may have heard you can do so ... Read Full Answer >>
  3. Are spousal Social Security benefits taxable?

    Your spousal Social Security benefits may be taxable, depending on your total household income for the year. About one-third ... Read Full Answer >>
  4. What are the best ways to sell an annuity?

    The best ways to sell an annuity are to locate buyers from insurance agents or companies that specialize in connecting buyers ... Read Full Answer >>
  5. Can my IRA be used for college tuition?

    You can use your IRA to pay for college tuition even before you reach retirement age. In fact, your retirement savings can ... Read Full Answer >>
  6. Why are IRA, Roth IRAs and 401(k) contributions limited?

    Contributions to IRA, Roth IRA, 401(k) and other retirement savings plans are limited by the IRS to prevent the very wealthy ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!