Some millennials are borrowing from their retirement to finance their homes, according to a recent Bank of the West survey. The question is: Should they be?
In July, Bank of the West conducted a survey of over 600 U.S. adults ages 21 – 34 and found that nearly one in three millennial homeowners have dipped into their retirement funds to cover down payments.
It’s an understandable, but flawed, line of thinking: You want to invest in a home now, and you’ll have plenty of time to replenish your retirement savings since retirement is so far down the road.
However, not only are there possible penalties and tax implications that come with prematurely withdrawing or borrowing from your retirement accounts, but there’s also the issue that you might not be able to fully recover from the losses by the time you’re ready to enter your golden years.
On the flip side, houses generally appreciate in value, the same way your retirement accounts likely will, so you might be able to get about the same amount of financial growth by investing in a home, with the added benefit of having a home to live in. However, it’s hard to predict which asset will provide more growth, and housing is not always the surefire investment people tend to think of it as.
Your retirement savings can be a useful safety net if you find yourself in dire need of cash, but is it ever a good idea to use it to purchase a house?
Borrowing vs. Withdrawing
Because retirement accounts like 401(k)s and IRAs are tax-advantaged, there are legal restrictions and regulations surrounding what you can and can’t do with the money you have tucked away in them.
When we refer to “borrowing” from your retirement savings, we mean it in the traditional sense: you borrow the money from yourself and have a set amount of time to pay the loan back, with interest. This is only available with some 401(k) plans, not IRAs.
When you borrow money from your 401(k) to pay for something other than a home purchase, you have to pay it back within five years. Loans used for home purchases can have longer repayment periods. You can borrow no more than 50% of your account balance, or up to $50,000, whichever is lower.
If you end up unable to pay back the loan, that money becomes taxable income. Not only that, but if you’re under 59 ½, you’ll be hit with a 10% early withdrawal fee.
For employer-sponsored retirement accounts, you also have to stay with your current employer while you pay back the loan. If you leave your job, voluntarily or not, you’ll have until your tax return filing deadline to pay the loan back in full or, according to the IRS, you’ll be subject to taxes and penalties unless you roll over “all or part of the loan’s outstanding balance to an IRA or eligible retirement plan by the due date for filing the federal income tax return for the year in which the loan is treaded as a distribution.”
It’s possible to get a loan from a self-employed 401(k) – also referred to as an individual or solo 401(k) – but your plan administrator has to offer this option.
You may also have the option to withdraw the money from a 401(k) or an IRA, but this can come at a high cost when you factor in taxes and penalties.
If your employer-backed retirement account allows hardship withdrawals, you’ll be able to take money out of your retirement savings for things like unexpected medical costs, school tuition or down payments on a home. However, not all plans allow this. You’ll pay income taxes and a 10% penalty on this withdrawal; although, the 10% penalty may not apply if you meet certain criteria, such as becoming disabled or reaching the age of 59 1/2 years.
If you have a Roth IRA or Roth 401(k), you’re allowed to withdraw the money you originally contributed (not any gains) tax- and penalty-free. For traditional IRAs, you can withdraw money penalty-free in certain situations, including a first-time home purchase.
Can You Really Afford It?
If you’re considering borrowing from your retirement to finance a house, consider if homeownership is your best option at this time. While many people view owning a home as an investment, the reality is much more complicated.
Marc Lieberman, chartered financial analyst (CFA) and CEO of Shorepine Wealth Management always advises clients against borrowing from retirement accounts.
“I would advise that if one is scraping up money to try to afford a home then they likely can’t afford that home to begin with. A home is much more than an investment. It requires constant maintenance, and that costs money,” he said. “If they are having a hard time finding money to afford a down payment what will happen when a pipe bursts or the furnace blows or a fence falls down?”
If you’re using the loan to finance a house, remember that homeownership will likely have an impact on your financial situation. On top of monthly mortgage payments, repairs and other costs that come with owning a home, will you be able to keep up with your 401(k) loan payments?
If you’re borrowing from your retirement because you’re anxious to be a homeowner and your retirement fund is your only source of money for your down payment, you may be setting yourself up for problems down the road. However, if you have enough money to safely withdraw from an eligible account, have cash on hand for inevitable home repairs and are confident you’ll be able to make up for the loss with your purchase, it might not be a terrible idea. It just depends on how much risk you’re comfortable taking on.
There’s also the issue of getting your retirement account back to where you were before you took out the loan/withdrawal and making up for the gains you potentially lost out on. It’s possible that your real estate investment may have similar growth to what you’d get in a retirement account, and it’s also good to keep in mind that retirement accounts aren’t immune from the volatility of the market. However, the stock market has historically seen higher returns than the housing market, and if you miss out on a market upswing, you could be robbing yourself of significant growth.
“Even borrowing from your account for five years can set you back considerably, and you may never be able to make up the loss,” Lauren Klein, certified financial planner (CFP) and founder of Klein Financial Advisors, said.
Is It Ever a Good Idea?
Before considering borrowing or withdrawing from your retirement savings, look at your larger financial profile. Are your earnings consistent? Is your retirement savings on track? Do you have any other savings? If you’re in a good spot, you might be able to swing it.
But in a nutshell, I’d say: Probably not.
“A home purchase is not an emergency, and I cannot think of any instance where it would be wise to ‘borrow’ from your retirement,” Klein said.
Instead, Klein said it’s best to focus on your long-term financial plan by building an emergency fund and making regular contributions to retirement.
“Once those basics are in place, you can start working toward your goal of purchasing a home – one dollar at a time, and without sacrificing consistent contributions to your retirement account,” she said.
There are a lot of downsides to borrowing from your retirement to fund a down payment on a home. Not only are you missing out on the gains from the money you originally had in the account, but if you’re unable to contribute to your retirement while you’re paying back the loan, you also miss out on that potential for growth as well, further curbing your efforts to save for retirement.
You may also be subject to double taxation: When you repay a 401(k) loan, you’re paying with money you’ve already paid taxes on. Then, when you ultimately take the money out for use in retirement, it gets taxed again.
There are steep penalties if you can’t pay back the loan. If your retirement account is your only financial safety net, you could be significantly compounding your problems if you end up in a situation where you need the money for something else, lose your job or are unable to meet the terms of the loan.
Why would anyone ever take out a 401(k) loan? If you know you’ll be able to pay it off quickly, it can be a convenient and fast way to get the cash you need. It also has this benefit: Any interest you pay, you’re putting back into your own account (or, paying yourself), rather than losing it to a lender.
You also have to seriously consider your ability to pay back a loan. Most people are pretty optimistic about their ability to repay a loan when they first take one out, but it can be hard to predict where you’ll be a few years down the road. Would you be able to recover from the heavy costs that come with defaulting on a 401(k) loan?
Everyone’s financial situation is different, so talk to a certified advisor or planner to figure out what your specific options are. In general, however, it’s not an ideal solution and should only be done when you’re out of better options.
There are usually some better options for getting the money you need.
If you’re trying to fund a down payment on a house, there are a variety of ways you can do so without dipping into your retirement savings. Depending on your situation, you may be eligible for a down payment assistance program, which can grant you money to help cover your down payment. There are also several mortgage options that allow low or even no down payments.
Freddie Mac and Fannie Mae both offer conventional loan options where buyers who qualify can pay a down payment as low as 3%. FHA loans can get you into a home with a down payment of just 3.5%, while USDA and VA loans can both be done with zero down payment. However, keep in mind that, with the exception of VA loans, when you pay less than 20%, you’ll have to pay a monthly mortgage insurance premium.
Gift money can also be used to fund home purchases. While it might not be a great idea to start hitting up all your friends and family for cash, if your grandma mentioned that she’d like to help you get into a house one day, tell her you’re starting to look.
Ultimately, you may just have to do it the old-fashioned way and budget, cut costs where you can and save your money. It’s not glamorous, and it requires patience and effort, but it’s a great way to have your cake and eat it, too.
The Bottom Line
There are certain situations where borrowing from your retirement savings may be your best or only option. If your retirement funds are the only thing left that can protect you from financial ruin, it could make sense to use them to pay off debt and avoid default.
However, if it’s not an absolute necessity, you’re probably better off not risking it. Homeownership can be an important milestone in a person’s life, but if you’re stretching yourself beyond your means to achieve it, you’re taking on an unnecessary amount of risk.
Your main goal should be to ensure that you’re being realistic and thinking long-term. By taking money from your retirement, you could be putting your future financial security in jeopardy.
“Saving for retirement is one of the most important long-term obligations you have to yourself. By funding your retirement early and allowing your assets to compound and grow over time, you can move forward with confidence and independence,” Klein said. “Your future self will thank you!”
We’ll say it again: Make sure to consider all options and consult your financial planner and/or tax adviser before taking a loan from your 401(k) or withdrawing from an IRA or any other retirement account. Whatever you do, take a holistic look at your finances before making any decisions.
What are your thoughts on borrowing from retirement? Share them in the comments!