How to Use Your Retirement Account to Buy a Home

Harry Jensen, Trusted Mortgage Expert with 45+ Years of Experience

Updated October 8, 2020

Saving enough money to buy a home, especially for a down payment, represents a huge challenge for many prospective homeowners.  One potential source of funds for home buyers is your retirement account such as a traditional IRA, Roth IRA or 401(k).  Taking money out of a retirement account involves rules, restrictions and potential penalties so it is not as simple as withdrawing funds from a regular bank account.  There are some regulations, however, that make it easier to use funds from a retirement account to pay for your down payment.

Once you understand your options, using money from a retirement account may provide the extra financial boost you need to buy a home.  Withdrawing or borrowing money from a retirement account is not without drawbacks but there are also advantages, especially for first-time home buyers and as you will read below, the definition of first-time buyer is fairly broad in this case.  While we do not recommend that you drain your retirement account to buy a home, using a portion of your retirement funds may enable you to make larger down payment, buy a bigger home or pay for renovations or closing costs.  The decision to use money in a retirement account really comes down to your financial priorities and balancing your desire to buy a home with saving for the future.

There are a lot of regulations that govern how much money you can withdraw or borrow from the different types of retirement accounts so it is important that you understand these rules before you access any funds.  Below, we outline how to use your retirement account to buy a home including what you need to know about program eligibility, withdrawal limits and potential fees.  When it comes to tax matters we always recommend consulting a specialist before you make any decisions but you can use the information below to better understand how the process works.

Use the First-Time Home Buyer $10,000 Exception

Borrowers have the ability to withdraw $10,000 from a qualified retirement account without paying a penalty to help them buy their first home -- this is known as the first-time home buyer exception. You typically pay a 10% penalty if you withdraw funds from a retirement account before the age of 59 1/2 so the exception is a helpful benefit for home buyers.  If you are married and you and your spouse are both first-time home buyers you can withdraw a total of $20,000 from your retirement accounts penalty-free to buy a home.

It is important to highlight that the definition of first-time home buyer is relatively flexible.  You qualify as first-time home buyer as long as you did not own your principal residence within the past two years. So technically you do not need to use the funds to buy your first home and you may be eligible for the exception even if you already own a property.  For example, if you own an income property that you lease and you have been renting your primary residence for the past two years, you qualify as a first-time home buyer according to government guidelines.

We recommend that you contact multiple lenders in the table below to learn more about their qualification requirements and how first-time home buyers can use the exception to help pay for the down payment on a home.

The funds that you withdraw from a retirement account under the exception can be used for a down payment, home construction or renovation projects and closing costs. You can also use the funds to help your children, grandchildren or parents buy a home as long as they qualify as first-time buyers. You must use the funds within 120 days of withdrawing the money from your account or the withdrawal is subject to a penalty. Additionally, it can take several weeks to access retirement funds so be sure to take out the funds early enough in the home buying process so the money is available when your mortgage closes.

The rules for withdrawing money to buy your first home from a Roth IRA are slightly different than for a Traditional IRA and we outline the differences below.  Finally, it is important to highlight that the first-time home buyer exception only applies to IRAs and not 401(k) accounts. 

Use Your Roth IRA

Accessing funds from your Roth IRA account is usually the most tax efficient way to use funds from a retirement account to buy a home.  Withdrawing contributions you have made to a Roth account is always tax and penalty free because you have already paid income taxes on that money so you can use as much of your Roth IRA contributions to buy a home without paying a penalty or additional taxes.

As long as your Roth account has been open for five years, first-time home buyers can withdraw up to $10,000 ($20,000 if your are married and both first-time home buyers) in earnings without paying a penalty or taxes.  To clarify, Roth account contributions are the after-tax money you contribute to the account.  Roth account earnings are the money your contributions earn, tax-free, in the account.

Withdrawals of earnings from a Roth account greater than $10,000 are subject to income taxes and a 10% early withdrawal penalty if you are younger than 59 1/2.  If your Roth account has been open for less than five years the withdrawal of any amount of earnings may be subject to income tax.

Use a Traditional IRA

First-time home buyers are allowed to withdraw up to $10,000 ($20,000 if your are married and both first-time home buyers) from a traditional IRA account without paying an early withdrawal penalty.  All withdrawals from a traditional IRA, however, are subject to income taxes.

So if you want to withdraw $20,000 from your traditional IRA account and you are in the 20% tax bracket you will receive $16,000 after taxes ($20,000 - $4,000 in taxes). Withdrawals greater than $10,000 from a traditional IRA are subject to both income taxes and a 10% early withdrawal penalty.

Use a Loan from Your 401(k) or Other Retirement Account

Depending on what type of retirement account you have and the rules for your retirement plan, you may be able to borrow money from your retirement account, such as a 401(k) or 403(b) to buy a home.  401(k) and 403(b) plans vary by employer but typically apply the same guidelines for loans to account holders, which we review in detail below.

You can typically borrow $50,000 or 50% of your vested account balance, whatever is less (this limit applies to each mortgage applicant so two people can borrow a maximum of $100,000 from their 401(k) accounts)

You do not apply for a loan from your 401(k).  Simply contact your plan provider, request the loan and you should receive the funds within one-to-two weeks

The term of the loan is typically five years although loans to purchase a principal residence may have longer terms (10 to 15 years).  401(k) loans do not have a prepayment penalty so you can repay the loan at any time.  We recommend that you pay off the loan as soon as possible so you can start growing your retirement savings again 

In some cases if you leave or lose your job for any reason the loan becomes due in full within two-to-three months. If you are unable to repay the loan, the outstanding balance is deemed an early disbursement and subject to a 10% penalty and income tax

Repayment upon separation from your employer is a significant risk that you should understand before taking out a 401(k) loan

The borrower pays interest on the loan with that interest going into the borrower’s 401(k) account. The interest rate on a 401(k) loan is typically higher than the interest rate on a first mortgage but lower than the interest rate on a second mortgage (also known as a piggyback loan) from a traditional lender

Loan payments are usually automatically deducted from your paycheck although you can also make additional payments on your own to pay off the loan faster. The payments made on a retirement account loan are typically not included as debt in your debt-to-income ratio when you apply for a mortgage because you own the assets that guarantee the loan and you make the loan payments to yourself.

Lenders, however, do require that borrowers provide documentation that outlines the key terms of a retirement account loan. You should check with your specific lender to determine how retirement account loans are treated when you apply for a mortgage.

You do not need to be a first time buyer to take a loan from your 401(k) to buy a home. Program rules vary so check with your 401(k) administrator to understand the specific terms for a 401(k) loan according to your plan. Borrowers could also consider taking a withdrawal from their 401(k) accounts instead of a loan but all 401(k) withdrawals are subject to income taxes and a 10% early withdrawal penalty so that tactic typically does not make financial sense.

Please note that with some plans you are not allowed to contribute to the plan while you are repaying a 401(k) loan.  This restriction limits your ability to save for retirement so be sure to understand the applicable guideline for your 401(k) plan. 

You can use our free personalized mortgage quote form to compare loan proposals from top-rated lenders in your area.  Our quote form is no obligation and does not affect your credit.

Use Your Retirement Account to Qualify for a Mortgage

In addition to using your retirement account for your down payment, you can also use your account to qualify for a mortgage.  There are two ways you can use your retirement funds as monthly income when you apply for the loan.

The first way is if you take regular distributions from your account.  As long as you can demonstrate that the distributions are expected to continue for at least three years, you can include that income in your application. 

The second way to use your retirement account to qualify for a mortgage is to use your funds as income without selling your assets.  In this case monthly income is attributed to liquid assets such as stocks, bonds, mutual funds and money market funds held within your account.  

Lenders apply a discount equal to whatever penalty you are required to pay if you withdraw your funds -- usually 10% -- and then apply an additional 30% discount to the current value of your retirement assets to account for market volatility.  Any funds you use for your down payment, closing costs and reserves are also subtracted.  The remaining value of your retirement funds is divided by the number of months in your mortgage term to determine the monthly income from the assets. 

For example, if you have $400,000 in liquid investments in your retirement account and the lender applies a 10% early withdrawal penalty and a 30% discount, that leaves $252,000 in net retirement funds to calculate your monthly income.  If you apply for a 30 year mortgage, the $252,000 in assets is divided by 360 months, which equals $700 in monthly income.  This income is added to any other income sources to determine the mortgage you can afford.   

To reiterate, with this approach you are not required to sell your retirement assets to use your funds as income when you apply for a mortgage.

Review Can You Use Retirement Account to Qualify for a Mortgage?

Consult a Tax or Retirement Professional

Before you use any funds from a retirement account to buy a home we recommend that you consult a certified accountant, retirement planning specialist or tax attorney to understand your personal tax consequences.  Consulting a professional requires extra expense and effort but can save you considerably more money and time in the long-run when you buy a home.

Sources

"Topic No. 557 Additional Tax on Early Distributions from Traditional and Roth IRAs."  IRS.  Internal Revenue Service, February 13 2020.  Web.

"Retirement Topics - Exceptions to Tax on Early Distributions."  IRS.  Internal Revenue Service, October 29 2019.  Web.

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