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. That’s especially true if they’re financing the down payment from retirement savings.
If you’ve got few cash reserves in your short- and long-term savings, you may not be prepared for the expenses that come with owning a home. That could put you deeper in debt, further complicating your financial situation over time.
Other consequences are even more worrisome. While the IRS waives the 10% early-withdrawal penalty (on traditional IRAs and Roth IRAs) for first-time homebuyers (up to a $10,000 lifetime limit), you’ll still owe income tax on the money. And depending on your income and how much you withdraw, it could push you into a higher tax bracket, costing you thousands more tax dollars at the end of the year.
Suppose you’re 35, currently in the 22% federal tax bracket and 5% for state, and you withdraw $30,000 for a first-time home purchase. Right away, you’re losing $8,100 to taxes—but if that $30,000 bumps you up into the 24% bracket, you lose another $600. And because the early-withdrawal exception only applies to the first $10,000, you’ll also owe $2,000 for the penalty on the rest.
What you lose in potential compounding 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. Assuming that rate of return, the $30,000 would be worth over $500,000 when you turn 65. (Past performance doesn’t guarantee future earnings, of course, but your opportunity definitely will have been lost.)
There are better ways to pay for college
More Americans are tapping their retirement Opens in new window to fund their children’s education as college costs continue to soar. However, that’s a short-term strategy with long-term impact.
The same income tax rules apply to withdrawals. And even though you won’t face an early-withdrawal penalty for using IRA funds toward college costs, you will get dinged 10% if you pull money from a workplace plan too soon. For example, if you’re 55, in the 24% federal tax bracket (5% state), and withdraw $50,000 for college costs, your withdrawal is worth just $30,500 after taxes and penalties. This assumes you don’t jump a bracket (and face even higher income taxes). Meanwhile, your “opportunity cost”—that $50,000 plus what it might have been over 10 more years if invested an S&P 500 fund earning 10% a year—is nearly $130,000.
All told, you could be looking at a potential hit of $99,500 or more ($80,000 in lost market returns plus $19,500 in taxes and penalties).
There’s a hidden factor at play, as well: The withdrawal counts as income when it’s time to apply for financial aid—but not in the same year. Specifically, the federal FAFSA® (Free Application for Federal Student Aid) Opens in new window looks at income from two tax years earlier, so your 2021 application will consider a withdrawal that appeared on your tax return for 2019. And the more income you report, the less your child might qualify for in grants and loans.
A tax-advantaged 529 account or Roth IRA—if you have other funds earmarked for retirement and are at least age 59½ and have held the account at least five years—is generally a wiser choice for college savings over the long haul.