From the desk of Ralene Nelson, Rio Vista REALTOR: If you have questions about what is the most cost effective way to buy a retirement home, feel free to contact me anytime.

If there was one thing I knew for sure last year it was that mortgage rates would be going up. They’ve gone down. According to Freddie Mac , rates on a 30-year fixed rate mortgage have fallen to 3.62% as of February 25, 2016. Last year mortgage rates rose above 4%. (If you’re reading this article several years from now and rates are at 8%, you have my condolences.)

Low rates make it an ideal time to buy a home. The primary hurdle keeping many from the American Dream, however, is the down payment. Even programs such as an FHA loan that requires just a 3.5% down payment can be a substantial sum for first-time homebuyers. Further, it can be a stretch to come up with a 20% down payment for those wanting to avoid private mortgage insurance, better known as PMI. For this reason, many look to retirement accounts as a source of funds.

Keep in mind that one can withdraw from a 401k or IRA at any time and for any reason. The issue, of course, is what are the consequences of taking a distribution. In the context of a down payment for a home, the issue typically is whether you’ll get hit with the 10% penalty, although the tax consequences can be significant, too.

We’ll first look at the rules related to using a 401k, IRA, and Roth IRA as a down payment. Then will consider the pros and cons of each option.

Using a 401k as a Down Payment

A 401k does not have a special exception for first-time homebuyers. An IRA does, which we’ll get to in a moment. With a 401k, the primary option is to take a loan from your retirement account.

A 401k loan is limited by law to $50,000 or one-half of the account balance, whichever is less. Loans typically must be repaid within five years, and interest on the loan is paid into the 401k account. In effect, you are paying yourself interest to borrow from your 401k.

Repayment of the loan is critical. If you are unable to repay the loan for any reason, the outstanding balance will be treated as a distribution to you, subject to ordinary income tax and potentially the 10% penalty. Further, if you are separated from your employment, you may be required to repay the balance of the loan in full.

Using an IRA as a Down Payment

An IRA provides a first-time homebuyer exception for early withdrawals. The exception permits a first-time homebuyer to take up to $10,000 for the purchase of a primary residence. To qualify as a first-time homebuyer, you cannot have owned a home as a primary residence during the last two years. A couple who both had an IRA could withdrawal $10,000 from each account.

While this exception avoids the 10% penalty, it doesn’t avoid taxes. The distributions would be considered ordinary income and taxed accordingly. The result is that the distribution would be taxed at your marginal rate.

Using a Roth IRA as a Down Payment

A Roth IRA provides several twists. Contributions can always be withdrawn at any time and for any reason without tax or penalty (remember, contributions have already been taxed). As a result, contributions to a Roth IRA can be a source of funds for a down payment on a house.

Earnings from those contributions, however, add a level of complexity. According to Charles Schwab,

With a Roth, withdrawals of contributions are always tax-free because you’ve already paid income taxes on that money. So are withdrawals of earnings of up to $10,000 under the homebuyer exemption, assuming you’ve had the Roth for five-plus years. But if you withdraw more than $10,000 in earnings, that money will be subject to both ordinary income taxes and the 10 percent penalty.

Source: ~ By: Rob Berger

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