The cost of homeownership is more than the down payment.
If your retirement account is your only source of down payment funds, you've got more to consider than just the financial consequences of early withdrawal. Most financial professionals strongly caution new homebuyers to look at the hidden costs of homeownership--major repairs, ongoing maintenance, property upgrades--before taking the plunge, especially if they're financing the down payment from a retirement account.
If you've got few cash reserves in your short- and long-term savings, you may not be prepared for the unavoidable expenses that come up when you own a home, and wind up going into debt, further complicating your financial situation over time.
Other consequences are even more worrisome. While the IRS waives the 10% early withdrawal penalty (on IRAs and Roth IRAs) for first-time homebuyers, income tax rules still apply. Depending on your income and how much you withdraw, you could find yourself in a higher tax bracket, costing you thousands of dollars in additional taxes at the end of the year.
Suppose you're 35, currently in the 25% federal tax bracket and 5% for state, and you withdraw $30,000 for a first-time home purchase. Right away, you're losing $9,000 to federal taxes--but if that $30k puts you into the 28% bracket, you lose an additional $1,000 on your withdrawal. Since that 10% early withdrawal penalty exception only applies to a $10,000 lifetime limit, you’ll also owe $2,000 for the tax penalty on the balance.
What you lose in compounded returns on your investment, however, is where it really gets painful. Imagine you leave that $30,000 in your retirement account in a fund that tracks the S&P 500, which has historically averaged about 10% a year. That $30,000 would be worth over $500,000 when you turn 65, assuming a historical rate of return.
There are better ways to pay for college.
More Americans are tapping their retirement to fund their children's education than ever before as college costs continue to soar. However, it's a short-term strategy with long-term impact.
The same income tax rules apply as above for any premature withdrawal, and there's a 10% penalty that applies in this scenario. If you are 55, for example, in the 28% federal tax bracket and 5% state, and withdraw $50,000 for college tuition, assuming you don't jump a bracket, your withdrawal is worth just $28,500 after taxes and penalties--and that $50,000 in an S&P 500 fund for an additional 10 years would be worth nearly $130,000 at retirement. Altogether, you could be looking at a potential hit of $96,000 or more ($80,000 in lost market returns plus $16,000 in taxes and penalties). Although there is an exception to the early withdrawal penalty for withdrawals from IRAs for higher education expenses, that exception does not apply to employer plans.
There's a hidden factor at play, as well: That money counts as income for any financial aid forms you submit in a following year (a withdrawal reflected on your 2017 income tax return will be reflected on your 2019 financial aid forms), potentially affecting your child's grants and loan package.
A tax-advantaged 529 account is generally a wiser choice for college tuition savings over the long haul.