GRD Season 4 Episode 3_Tapping Your Retirement Account for a Home_mixdown
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[00:00:00] Hi, I'm Ed Slott. And I'm Jeff Levine. And we're two guys who just love to talk about retirement and taxes. Look, our mission is simple to educate you the saver, so that you can make better decisions because better decisions on the whole lead to better outcomes. And here's how we're going to do that. Each week, Jeff and I will debate the pros and the cons of a particular retirement strategy or topic with the goal of helping you keep more of your hard-earned money.

At the end of each debate, there's going to be one clear winner you. A more informed saver who can hopefully apply the merits of each side of the debate to your own personal situation. Decide what's best for you and your family. So here we go. Welcome to the Great Retirement Debate. Hi everyone, and welcome to the next episode of The Great Retirement Debate.

I'm Ed Slott, and with me here is Jeff Slott. And today, Jeff. We're talking about, should you tap your 401k, even take a loan from your 401k to buy your first home? What do you think [00:01:00] about that? Well, I think we, we start with the fact that in general, retirement accounts should be preserved for retirement, right?

Like there's a reason they're called retirement accounts. 401k would be one of those. And if you take money out of your plan or any other type of retirement account, you are reducing the amount of money you're gonna have available later at a time of your life when it may be harder to work, uh, and to earn money than it is today.

So I think that's a, a good starting point, but when it. When it comes to, should you as the listener here, or maybe it's not you, but maybe you're listening today and thinking about your child or your grandchild or some other friend or family member who you're close with, when, when the, the, going through that thought process, right?

It, it's not always all about math. There are, you know, stages of life where things are really important for you and for a lot of people there's really not a price you can put on having a home to raise your family or to, to, to be with a, a, a loved one or whatnot. There's, [00:02:00] you know, there's a non-financial element to this and some people may be willing to.

Forego other things later on in life in order to have a home at a time of their life when it may be more impactful than in the future. So should you do this, ultimately answer it? I think, uh, you know, we'll probably spend the next 15, 20 minutes on backing this, but it depends, right? It's just like anything else in the financial arena.

It depends upon your specific facts and circumstances and what's important to you. In the past, I would agree with everything you said. You know, your retirement income, your retirement is for retirement if you spend it now, I used to say that in every seminar, but that was more for the taking money out and paying a 10% penalty before 59 and a half, and you do that, what are you going to have left for retirement?

And that was more towards spending it on like a big TV or things like that, that really have no long-term, uh, growth potential. Uh, but. You know, I've been looking into this recently because there is sort of home crisis, and [00:03:00] again, for most of the people that listen, actually I don't really know, but I think we have an older audience or maybe, what would you say, fifties or something like that for our podcast.

I think it's all, but I think most of our audience has a home already. If they, if they right. Yeah. That's a better way. Yeah. Forget older has a, is already a home. Well, actually I think what Ed, I just wanna. Whoever you are listening today, Ed just called you old. I usually call Ed old, but that's Ed and I, Ed just called you old.

So how do you feel about that? Yeah. Alright we have a mature more home bo people that have already, we have a, we have a, a high percentage of homeowners as listeners. Yes. Yeah. And that's a great way to put it. Alright. And so you may think, well, I've already done, I think you've offended all of our listeners.

Ed, tell us what you think. Yeah. Okay. Uh, but for your children or grandchildren, I've been looking into this and almost every study says exactly what Jeff said. It's not based on the numbers. People want a home. Young people want a home. When they want a home, they're getting married, they're starting a life, they want a home.

You could show them the numbers and they'll say, we'll make it work. We want a [00:04:00] home. We want that home. It's going to cost that much, and we'll pull the money from wherever we have to do it. And it may make sense in certain situations. And what I'm really talking about is taking a loan from your 401k. Now, I think we've done podcasts in the past on whether it pays to take a loan from your 401k, and I think I was, or maybe you said it.

I don't remember that. We said, that's generally not a good idea because you're taking money out, you have to pay it back. You end up paying twice. You know, we went through all of that. But now I'm thinking, you know what? So here's what you're doing. You're borrowing from your 401k, which still has to be paid back 'cause you need money for closing to make it work.

And generally younger people have lower balances. So I'm talking more about for closing expenses. Younger people in their twenties. They can borrow up to say 50% or so, but what's 50%? If they only have 30, 40 or 50,000 in there? Maybe if they're in [00:05:00] their thirties, they have a hundred thousand. So we're talking about getting into the home.

So you, yeah, and it's worth pointing out Ed, that no matter how much money you have, at least based on today's rules. The most you can borrow from your 401k is $50,000, right? Right. You have $10 million in your 401k, and you can borrow $50,000 at a maximum. If your balance is smaller, it may be smaller than 50,000.

Right. Right. So there's the overall limit, which should cover most average home closing costs to get into the house. Sure. That's really what we're talking about. So the theory was, uh, and I think we've both kind of argued that that's probably not a good idea, but if you look at it long term, and that's what I'm looking at now, I may change my position in certain cases because what are you really doing?

People want the home. Now, people in their twenties or thirties, the average person buying a first home now is over. 30 years old. That's how tough it is now is over 30 years old and they want a home. The they're not thinking, and you may [00:06:00] correct me here, and other people will, they're not thinking well, their first priority isn't saving for retirement.

Of course, they're thinking for retirement. They're putting away in a 401k, but that's not the pro priority. They want the home. So I'm thinking. Why keep building up a taxable 401k anyway, and this is just a loan so it goes back. Hopefully you can repay the loan. That's a big consideration. So really all you're doing is trading the 401k, which may not be a good long-term asset for a better long-term asset with more equity, more tax advantages in your home.

Plus you want the home. Yep. Yeah, I, I think all of that's fair. Uh, what I would point out just a, a few on the technical side here for those thinking like, well, is this good for me or for my child, whoever else I'm thinking about, you know, the first thing is if you have a 401k. Doesn't automatically mean that you can borrow from it.

Right? Right. Every 401k is different and not all plans will allow you. It's actually a, a plan by plan [00:07:00] decision. The employer can kind of set those rules within the IRS parameters, but many plans do allow that. Right. And again. You're able to take out. Now, generally speaking, a loan has to be paid back within five years if you take it out of a 401k, but there are actually some special provisions in there.

If you use it for a home, you can actually get a little bit longer timeframe over which to pay that back, but ultimately, I think it's really important to remember that. It is a loan just like anything else that you said, Ed, you're, you're borrowing from yourself effectively, but at the end of the day, it is going to be like you, you still have to be able to afford the house, but if you're going to have to take that loan from somewhere now.

When rates at the bank were next to nothing, right, and you could get money relatively cheaply. Well, that it seemed like it was generally a much better place to take money from the bank. Now that interest rates are a little bit higher than they were, you know, depending on where we are today, it it, it's north of zero, which is where it was not too long ago.

Right. [00:08:00] A lot of people were taking loans. The higher the interest rate at the bank, the more it may make sense to consider using your own money because it lowers the amount of money you have to pay back to the bank over time, you pay yourself and there's an interest rate associated with that, but it's generally less than it would be.

And again, you're paying back that interest to yourself in the 401k loan. Right, but my point is it's going back. That's all true. And uh, but again, you're still depleting the balance and you have to put it back in. Uh, and that could be a problem long term. But the point is that I'm looking at more now is, you know, the, the home could be a great part of a future retirement. You know, in the retirement, a lot of times people's homes, uh, a, along with their IRA are their biggest assets in retirement. But the IRA or where there's 401k money will a will eventually end up in most cases. So that's why I'm saying the IRA. The IRA is a fully taxable [00:09:00] account where the home has all kinds of tax advantages when you sell or you leave it to heirs or you can tap it for reverse mortgages.

It's a great source of equity in retirement, so you might look at it that way to say, you know what? It might be better to build that asset, uh, than the 401k. In a large respect, you're not so much spending the money as you are transferring it from one asset to another. Right? And, and then there's a big difference there, right?

If you wanna borrow from your 401k to go on a vacation, that money, the, the value there is effectively gone. If you put it into a home. It, you're just trading one asset for another. It's like moving money from a stock into a, you know, selling it and having it go to the cash, go into a bank account. You still have the same amount of an asset.

It's just you've transformed. Its, uh, now Ed, we, we've primarily been talking here so far, about 401k. Uh, you also already mentioned that most people tend to, when they have the opportunity, move money from 401k into [00:10:00] an IRA. So I think it's at least worth us discussing here. If the same principles apply to potentially taking money out of an IRA in order to pay for it, and, and I think there we have to begin with.

The rules, unfortunately, for IRAs, for individuals thinking about this, are very different than they are for 401ks with a 401k, you do have that ability to take a loan. A loan for an IRA is what's known as a prohibited transaction. It is a no-no. Uh, the biggest no-no of no-nos. In fact, uh, if you were to borrow even just.

You know, $10, like you're $10 short for your closing, but you've got $500,000 put away and you say, I can't go. You go around, you ask everybody you know, and no one's gonna give you the $10. So you go and you borrow it from your IRA. That $10 you just borrowed from your IRA makes the entire $500,000 in that account taxable all at once. And of course, if you're under 59 and a half, which a lot of home buyers that would be in this position would [00:11:00] be, it's not only the income tax, it's the 10% penalty on top of that and could easily destroy a retirement savings. What would've been so far, a lifetime's worth of savings would be taxable all at once, subject to a 10% penalty and really could erode wealth long term.

So the idea of doing this from an IRA. And borrowing doesn't work. But there are, in fairness, at least some benefits that could be available from an IRA, right? Ed? Well it you first time home buyer, you, you'll pay the tax. In other words, if you are using IRA money, that's taxable money you can't borrow.

That's the big difference with a 401k when you borrow, that money's not taxable. That's why it's attractive to young people. Say, look, I could take this money without increasing my tax bill if I take it from an IRA. I increased my tax bill. Now there is a special provision, again, we're saying most first time home buyers are probably 99% or under 59 and a half.

Uh, you'll have a 10% penalty, but there's a special [00:12:00] exception, but only for a small limited amount, $10,000 lifetime. Again, that's not even enough to cover average closing costs. So that's the most you can get out penalty free $10,000 over your lifetime from an IRA. The rest would be taxable and subject to a penalty.

But let's go back now. Now we're in different territory. Would it pay? Now we're talking about a loan and you said, you know, the loan amounts could be small, 50% of your balance. Younger people, even if they have a hundred thousand or more, the most they can get is 50,000. That may get them over the hump, but.

Would we go even farther? Would it pay to take a taxable distribution with a 10% penalty to get you into your first home? I don't know about that. You'd have to see the numbers going out. Normally a 10% penalty for anything in the tax code other than the NUA tax break net Don't realized appreciation is a [00:13:00] deal breaker for me, so I don't know.

That might be a deal breaker for. For, for me, I'm not worried about as much about the tax because you're getting the money out while they're in a lower tax bracket. Most young people are in a lower rate. The tax is gonna be minimal and maybe even the penalty might be minimal based on their level of income, uh, uh, based on their level of income, how much they take.

The 10% is based across the board on what they take, but the tax that's right would be much lower. So you, and it's worth pointing out for those individuals, like even if you have negative income, you still have to pay the penalty. Right, right, right. Yeah, I remember that happened. There was a court case a number of years ago where that, uh, they decided that, in other words, yeah, if you've got like $25,000 of income and you wipe the whole thing away with your standard deduction, but you took out 25,000 from your IRA, you've gotta pay a $2,500 penalty on that, even if you have enough.

The like credits and every, like you, you, the credits can offset a penalty, but negative income can't. So it, it's, [00:14:00] you know, and I think about it. Well, isn't a deal breaker, that's the thing, because if you're getting money out and said this, at least I feel this way, getting money out of the 401k is probably good.

While rates are low, it's the 10% penalty. Will a low rate make up for the pen paying the 10% penalty down the road when the, when the funds are in a better asset in a home? So I, I think the answer to your question and the answer to the, should you take the money out to pay down, like, and pay the 10% penalty, all of those things are, are related to, to, to the idea of like, if you have the thought that you might want to buy a home in the somewhat near future.

And I realized things change. People's priorities change you. You know, you aren't planning on kids. Maybe you have kids, maybe you're planning on one and you find out you have triplets and you need a bigger hat. Like whatever it is, right? Like things happen and you can't always foresee and plan for the future in, in, in, um, you know, with, with perfect, uh, [00:15:00] clairvoyance, right?

But. If you're thinking like, I may need this money, then maybe the retirement account is not the best place to put it in the first place, right? So if your, if your choice is, Hey, in three or four years, I may wanna use this money to buy a house. Then you're probably, you know, better off not putting it in the retirement account, paying tax today at your low rate, but without a 10% penalty, stuffing it in a regular taxable account and having it available for the purchase of that home.

Now if you, you, again, you don't know, then it comes down to should I pay the tax and the penalty? And it's probably not a great financial move in a lot of those situations, but again, you know, I think you've hit on it a couple times. A, a lot of people just, I don't care, right? Like, I don't care. I want the home.

I want a house. I have, you know, the situation I'm in now, I'm relatively young. I want to win. I'm, I'm not gonna get these years back of my life, right? So let me, you know, let me, and, and that's just a personal choice. Mathematically, [00:16:00] financially, it's probably not the best decision, but, well, I don't know.

Look at the home as an invaluable asset in retirement. Paying tax on the 10% penalty, the bathroom is hard to make that work. Yeah, I know. It bothers me too. To me, it's somewhat of a deal breaker. What I was thinking, if you can get that money out at such a low rate out of your 401k, does, does that offset, does it take the edge off the penalty and just Well, if there even there, right.

If you were thinking that way, then you, you, you again, you just don't put it into the retirement account. Right, right, right. Pay, pay, pay the tax today, and then you don't have the 10% penalty. You know, just don't put it into a retirement account. And, and I think that's a, a fair discussion too, right? When you're Yeah, that's a good point.

You know? Yeah. When, when you're, when you're in this early stage of life and you perhaps have different priorities and goals, the retirement account may not be the best thing for you. Or one more here, ed, that we haven't talked about is if you have far enough [00:17:00] forethought, right? Like, hey, I am 25 now, but at 30 or 31, you said the average homeowner now today is, you know, past 30 for their first home.

You know, if I'm thinking, Hey, I'm 25, but I may want to use this money in the future at 30 or 31 to buy a house, maybe convert today. And one of the things that's really unique about the Roth IRA is anything you convert today, if you wait more than five years. You can take it without a penalty, so you can pay the tax today and listen.

For argument's sake, let's say our 25-year-old happened to be a really great saver and had already put away, you know, $70,000 into a 401k. I said they were a great saver, ed. All right? They were great. So our 25-year-old put $70,000 away into their 401k already. They've been maxing it out for the first, you know, two or three years of their working and the $70,000 they convert today.

Goes to, you know, $120,000 by the [00:18:00] time they're, uh, they could take out, if it's in a Roth IRA, they could take out $70,000 the amount they converted today without a tax or penalty. When they're 31 after five years, there is no tax, no penalty on the amount they converted, not the earnings. The earnings would still be subject to income tax and a penalty, but again, that gives you another way to potentially think about using your retirement funds now for a future home purchase in a tax efficient way.

Even without the 401k, the conversion, a better idea if you have limited funds, is just do Roth IRA contributions for the seven or 8,000, whatever it is each year and build up there. Contributions, uh, can be withdrawn, tax and penalty free at any time for any reason. It's a good parking place for future planning.

But here's the problem with all of that. I don't know anybody who really plans out when they buy a home. You're 25, you might be thinking about it, but then [00:19:00] all of a sudden you get married. You do. I want it now. There's no planning. It sounds good. So here's the message to our homeowner listeners, not older listeners, home homeowner viewers watching this.

You might plant that seed with your kids or grandkids that might be thinking about buying a home and say, you know what? You might be thinking about it or maybe not. But if you think you want a home, and most of them do, almost every young person wants to buy a home. Uh, every study has showed that, that I've seen or heard about, and.

How about putting money away in your Roth? IRA, just saying, you know, maybe not fill up in the 401k. Put it in a place that if you do want to, you can do all the things you talked about. So just to recap everything we talked about, should you use your retirement account, your 401k or IRA to buy a first home?

We talked about several ways. The big way, uh, was to take a loan from the 401k. You can't do that from an IRA and that gets paid back and it's not taxable. [00:20:00] If you need even more money, you might take an actual distribution, but you'd probably pay a 10% penalty. With an IRA, you can take a distribution and the first $10,000 is penalty free if used for a first home, but that's once in a lifetime, or I like what you said there, if people have the foresight to plan. Don't put the money in the 401k in the first place. Use the Roth 401k or your Roth IRA instead. But the, the problem with that is most people get their job. It's like a knee jerk reaction. It's almost default. You go right into the 401k. I don't even know if younger people know, they should probably go right into the Roth 401k and not the 401k, but everybody goes right into the 401k.

So that's where the money is. And of course if you convert in the 401k yeah. You may not have the same, you know, the Roth IRA has different distribution rules, right. Than the Roth 401k. Right. Which make it the Roth 401k not as quite, uh, as efficient, but, uh, yeah. So I, I look, I think all [00:21:00] of that makes a lot of sense, ed, and, and look ultimately.

Uh, the point here is that listeners are able to borrow, no pun intended, some of this, like it may be pun intended, uh, some of this information in order to help those around them make better choices. And here at the Great Retirement Debate, our goal is to always make the winner of the debate you a more informed and knowledgeable consumer who can make better decisions because better decisions on the whole.

Lead to better outcomes. And that's what Ed and I are on a mission to help you accomplish. So Ed, thanks so much. This was a fun topic, one we don't normally get to to talk about. This was good, right? Yeah. And I've changed my thinking on this quite a bit. Alright, well thanks so much and have a great day and we'll see you next time on the Great Retirement Debate.

Jeffrey Levine is Chief Planning Officer at Focus Partners. This podcast is for informational and educational purposes only, and should not be construed as specific investment accounting, legal or tax advice. Certain information mentioned may be based on third party information, which may become outdated or otherwise superseded without notice.

Third party information is deemed to be reliable, but its accuracy and [00:22:00] completeness cannot be guaranteed. The topic discussed and corresponding arguments are those of the speakers and may not accurately reflect those of focus partners.