Dead set on buying a beachfront vacation home or an investment property on a lake with a view? The catch: You don't have the money for a down payment or to do an all-cash deal. Should you raid your retirement account to get the deal done?
You're probably not going to like the answer.
"No, unless you have no other choice," said Kendall Mead, a certified financial planner at SoFi, a bank. The answer is maybe a yes, though, if you're lucky enough to have a retirement account balance so sizable that the lump sum withdrawal won't derail your golden years. You might also consider it if grabbing the new place is your No. 1 priority. Perhaps you're simply willing to eat the added tax costs and accept the other financial negatives related to the lump-sum distribution.
Withdraw With Care
Most Americans, though, should think long and hard before tapping a retirement account to buy real estate, personal finance pros say. Sure, the money sitting in your 401(k) or IRA is yours. You can use it as you see fit. "You can take money out, there's no law prohibiting it," says Tim Steffen, director of advanced planning for Baird, a wealth management firm.
But there are downsides to using your retirement account to fund a big purchase like a second home or rental property.
Beware The Big Tax Hit
Most people have the bulk of their retirement money in traditional 401(k)s or rollover IRAs. But that means the money you've socked away and the gains you've earned have never been taxed. Thus, taking a big lump-sum withdrawal from a retirement account that's funded with pretax dollars will cost you on Tax Day.
"Whatever you take out is going to be fully taxable as ordinary income," according to Steffen.
Let's say you need $200,000. The IRS will tax that income alone at 24%. That's because the amount is more than the $190,750 that puts couples filing taxes jointly into the 24% tax bracket. So, roughly to come up with 200 grand for a down payment will cost you closer to $250,000 once you factor in taxes. "That's a big dollar amount," said Nicole Birkett-Brunkhorst, a wealth planner at U.S. Bank Private Wealth Management. (And folks younger than 59-1/2 will also be hit with a 10% early withdrawal penalty.)
Watch For Double-Whammy Tax Hit With Investment Property
And that could lead to yet another drawback. Yanking such a large sum from your retirement account could also push a big chunk of your overall income into a higher tax bracket. And that double-whammy tax hit makes using money from a retirement account to buy real estate even less cost effective. Ideally, you're better off taking retirement distributions when your income is low. Doing so results in a smaller tax hit.
One way to dodge a big tax bill is to simply take a loan from your 401(k). The IRS only allows you to withdraw the lessor of 50% of your vested balance or $50,000. But the loan won't trigger a taxable event or push you into a higher tax bracket.
Another plus is you pay yourself back with interest. The downside is loans don't allow you to gain access to a lump sum larger than $50,000. And 401(k) loans are tied to the prime rate, which is now 8%, plus an additional 1% or 2% depending on the plan. So, right now you'd be paying 9% or more in interest to gain access to the funds.
Protect Your Account's Growth
Another downside of taking a big lump-sum withdrawal all at once from a traditional 401(k) or IRA is it shrinks the number of shares and dollars left in your retirement account. And that means you'll have less money invested in financial markets to grow over time. That leaves less money to fund your retirement later in life. "For most people, that means they're losing a large chunk of retirement savings," Steffen said.
There's another potential portfolio headwind when pulling funds from your retirement account when financial markets are volatile and your assets are trading at depressed prices. You'll have to sell more shares that you own than you would have to sell in a bull market to raise the same amount of funds, adds SoFi's Mead.
And that compounds the cost of using your 401(k) to buy your vacation dream home. "If you're selling at the bottom, you're not giving that money a chance to gain back what it lost," Mead said.
Make Sure You Have Enough Money
If you deplete too much of your nest egg and don't have enough assets left to grow over time, you risk falling short of your financial goals. Retirement savings accounts are designed to generate income you need after you stop working.
"Relying on 401(k) dollars to be able to fulfill your homeownership goal could jeopardize your retirement savings strategy," Birkett-Brunkhorst said. That's why it's important, she adds, to do a cost-benefit analysis. That way you'll better understand some potential retirement-savings blind spots.
Consider Other Options
Since the cost of using a traditional pretax retirement plan to buy real estate isn't the most tax-efficient use of your nest egg, what's a potential homebuyer to do?
If you're an existing homeowner who has substantial equity in your home, you could tap the equity to pay for your down payment or close the deal on the house in cash, notes Mead. However, adding a second mortgage might result in a too-high debt-to-income ratio to get approved for a new home equity loan or home equity line of credit. For those who already have a HELOC, you can tap it if you want. Just make sure you can manage the monthly payments over the long term.
Another option is to draw from assets you may have in a Roth IRA. The reason: Since your Roth was funded with after-tax dollars, your withdrawals are tax-free. Pulling from a Roth retirement account, though, still results in a smaller nest egg with less growth potential.
Tap Taxable Accounts For Investment Property?
Withdrawing from a taxable brokerage account is another funding option. This move can be more tax-efficient if you have held assets for more than a year. So-called long-term capital gains rates range from 0% to 20% and are typically lower than ordinary income tax rates.
You could also sit down with a mortgage loan officer and run through all your assets. Don't overlook dollars sitting in traditional 401(k)s and equity in another home you own. You might get approved for a loan with a smaller down payment.
And if you're OK with using your 401(k) to raise funds for a real estate purchase, it comes down to this: "You've got to decide what's the priority: having the second home or maybe being able to retire a little bit earlier because you've got enough savings built up," Steffen said.
