A few weeks back, I was having a chat with a younger friend who raised the following:
“I was hoping to talk about 401K vs saving money to have disposable income to eventually buy a house in the somewhat near future. I’m not sure how much I should be putting in my 401K.”
In other words: “Should I save for retirement or save for a home down payment?”
This question is so essential to millennial personal finance that I’m surprised I have never been asked it before, or thought of it on my own as a topic to write about.
My immediate response, and the most basic general rule that I can imagine applying to this situation is,
“Get your full 401K match first each year, then save for a home.”
Free money is free money, after all. Even if it delays buying a home for a while, it’s worth it.
I should also note that that this person lives in the San Francisco Bay area – so my next nugget of wisdom was “But you should NEVER buy a home in the Bay anyways!”. But back to the actual question – what if my friend could choose both?
The IRA Qualified First-Time Homebuyer Distribution Rule
Later on, as I got to thinking about his question further, I then remembered the qualified first-time homebuyer distribution rule exception for IRAs. Contributions to a Roth IRA can be withdrawn tax-free and without penalty at any time – which is great for first-time homebuyers. Earnings (on Roth or other IRAs), however, cannot normally be withdrawn prior to age 59.5 without paying a 10% tax penalty.
But, with the qualified first-time homebuyer exception for IRAs, up to $10,000 of earnings on your contributions could also be penalty-free. IRS Publication 590b states,
“Even if you are under age 59½, you don’t have to pay the 10% additional tax on up to $10,000 of distributions you receive to buy, build, or rebuild a first home.”
The rule goes on to state,
“To qualify for treatment as a first-time homebuyer distribution, the distribution must meet all the following requirements.
- It must be used to pay qualified acquisition costs (defined next) before the close of the 120th day after the day you received it.
- It must be used to pay qualified acquisition costs for the main home of a first-time homebuyer (defined below) who is any of the following.
- Your spouse.
- Your or your spouse’s child.
- Your or your spouse’s grandchild.
- Your or your spouse’s parent or other ancestor.
- When added to all your prior qualified first-time homebuyer distributions, if any, total qualifying distributions can’t be more than $10,000.
This rule is true for all IRAs: Roth, Traditional, SEP, and SIMPLE (note: with this exception, you won’t pay the 10% early distribution penalty, but you will still have to pay regular income tax on non-Roth IRA distributions).
Penalty-free IRA distributions seems like a great compromise if you want to simultaneously save for retirement, but also keep your options open for a future home purchase.
Are there First-Time Homebuyer Penalty-Free Distribution Exceptions for 401Ks?
Naturally, the next question is if there are also penalty-free distributions for first-time homebuyers for 401Ks (and other qualified employer-sponsored plans).
This would more directly impact younger workers who do not yet have an IRA, as the only retirement account they may have is their current employer-sponsored plan.
Unfortunately, 401Ks (and similar employer-sponsored plans) do not have a qualified first-time homebuyer penalty-free distribution exception, according to the IRS.
It is possible that you could make an “in-service distribution” to an IRA while you are still employed, but employer plans vary on whether they allow this or not. If yours does – this would be the optimal solution. You could save for retirement, get your matching funds, and also make a distribution to your IRA (where distributions on earnings could later be eligible for the first-time homebuyer exception). This would require some homework, planning, and foresight.
What About a 401K Loan?
I hate to even bring up the 401K loan as an option for buying a home, because I view them only as a “last resort lifeline” due to their significant downsides. And buying a home is not a last resort scenario. Consider the following downsides,
- You’re robbing from your future self: in order to pay for today. While you are paying yourself back (hopefully), you are missing out on the power of compound investment returns that your retirement could be reaping.
- Double taxation: 401K loan repayments are being made with after-tax dollars and are not tax deductible. At the same time, distributions in retirement are also taxed. That means you will pay income taxes on the same money twice.
- Huge default risks: If you don’t make a payment within 90 days, you are in default and defaults are treated as an early withdrawal distribution. This means your withdrawal money is considered taxable income. Even worse, you must also pay the 10% early withdrawal penalty if you’re under age 59.5.
- Limitations on loan size: the IRS limits 401K loan amounts to (1) the greater of $10,000 or 50% of your vested account balance, or (2) $50,000, whichever is less.
- Impact on Mortgage Qualification: technically, the loan is considered debt you must pay back, which can impact your credit worthiness with mortgage lenders.
- Stress of job security: What happens to your 401K loan if you quit your job or get fired? In most cases, you only have 60 days to pay the outstanding balance of your loan. Any that you do not repay is considered in default.
- You’re probably not contributing to a 401K: while you’re having funds deducted from your payroll to pay back a 401K loan. This means you’re missing out on additional contributions and any associated employer matching 401K contributions.
You’ve been fairly warned. If you need to take out a loan against your 401K in order to make the financial of buying a home work, then you’re probably not financially ready to buy a home.
Save for a Home or Retirement? A Summary:
As noted, before saving for a home, always get your maximum employer match each year, even if it requires you going up to the maximum 401K contribution to get it.
Next, pull from your your non-retirement savings, which is always preferable to retirement savings.
From there, if you need to dip into your retirement accounts, your options for a first-time home purchase payment are:
- Roth IRA Contribution Distributions: income tax free and 10% penalty-free.
- Roth IRA Earning Distributions, up to $10,000: income tax free and 10% penalty-free under first-time homebuyer distribution exception.
- Traditional IRA, SIMPLE IRA, & SEP IRA Distributions, up to $10,000: taxable income, but 10% penalty-free under first-time homebuyer distribution exception.
- Roth IRA Earnings, over $10,000: taxable income + 10% penalty.
- Traditional IRA, SIMPLE IRA, & SEP IRA Distributions, over $10,000: taxable income + 10% penalty.
- 401K Loan: no income tax or penalty (unless payments are missed), but serious downsides and risks.
- 401K (or Other Employer Plan) Distribution: taxable income + 10% penalty.
I want to stress that nobody should ever feel an urgency to become a first-time homebuyer. A home purchase is financially life changing. And there will always be opportunities to buy down the road. The most important thing is to hold off on buying until you are ready and have proper cash flow to do so. And if you’re even considering taking a tax penalty or 401K loan, that’s a sign that you are not ready.