Darn! I Can’t Use My Retirement Plan to Help Me Purchase a Home. Or Can I?

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by Chris Tanner

A popular belief is that you cannot use retirement funds to help with the purchase of a personal residence. Oh sure, you could take a distribution from your IRA and get hit with ordinary income tax, and worse yet, if you’re younger than 59½ the IRS will hit you with a 10% early withdrawal penalty. So, if you took a $100,000 distribution from your IRA, how much are you likely to pay in taxes?

Federal Income Tax @ 24% (middle tax bracket for married filing joint in 2019) = $24,000.

State Income Tax @ 5% (varies greatly! Could be Zero, or as high as 12.7% if you live in New York) = $5,000.

Early Withdrawal Penalty @ 10% (If under 59½ at the time of the distribution) = $10,000.

That’s a whopping tax hit of $39,000! In other words, your $100,000 only gives you $61,000 in purchasing power.

Of note, the IRS does allow FIRST TIME homeowners under the age of 59½ an early withdrawal exemption, but ordinary income tax still applies (*see the end of this article for details).

Hmm? The tax consequences for early distributions are quite punitive, and that’s why most people would not use this method. But what if there was an IRS approved way to tap into your retirement plan, AND pay NO taxes?? Read on...

Most employer sponsored retirement plans have a personal loan provision, and some of them have a SPECIAL provision for the purchase of a personal residence. What kind of retirement plans can offer a personal loan? 401(k)s, 403(b)s, 457(b)s, and defined benefit/pension plans. How would you know if a loan option is available? Call the plan provider and ask them or read the plan documents. IF, and ONLY if the plan documents include the personal loan provision, then you have the option of taking a personal loan. Please be aware of the IRS rules about personal loans:

  • An individual can borrow a maximum of $50,000 or ½ of the account value, whichever is greater.
  • Maximum length of the loan is 5 years (MIGHT be an exception for the purchase of a personal residence. Read below for details).
  • Loan must be fully amortized (No interest only loans).
  • Must charge yourself a “reasonable” interest rate.
  • Need to make at least Quarterly payments, or the loan could be subject to distribution if you pay less frequently. You can make loan payments more frequently than quarterly, but not less frequently.

To wrap things up, let’s discuss the special loan for the purchase of a personal residence. If, and ONLY if the employer plan has this option available, you can borrow from your retirement plan for the purpose of purchasing a personal residence. So how is this different from the personal loan mentioned above? The IRS allows for a longer repayment period. The 5-year loan can be extended to a “reasonable” amount of time. What is reasonable? That is determined by the plan documents. If the plan document says 20 years, then you can borrow for up to 20 years. Extending the repayment period may be exactly what you need to help with the purchase of your next home.

What if your employer plan does NOT offer a personal loan option, or what if they do not offer the extended loan option for the purchase of a personal residence? Is there another option? Perhaps. There is a retirement plan called a solo 401(k) that allows you to establish the plan document rules. Since you establish the rules, obviously you can incorporate both a personal loan option and the personal residence loan option. This plan may be a fit for the self-employed, or individuals that own a business. I hope you found this information useful. I welcome questions, comments, and feedback.

Please see the FAQ’s below regarding personal loans from an employer sponsored retirement plan.

FAQs

Q: Are employers required to offer the personal loan option, and or the purchase of a home loan option?
A: No, it’s totally up to the employer’s discretion.

Q: Are there fees for setting up a personal loan from my employer’s retirement plan?
A: Most plan administrators will charge for setting up and managing the personal loan. Check with the plan sponsor, they can tell you if there are fees, and what those would be. If you utilize a solo 401K that you manage personally, there would be no fees.

Q: What happens if I can’t make my personal loan payments?
A: Unfortunately, the remaining balance of the loan would be considered a distribution, and you would likely be taxed on the distribution.

Q: What happens if I leave my employer but still have an outstanding loan balance?
A: Ask your plan sponsor!! Fair warning, some plan sponsors will require you to repay the loan within 60 days of your separation, and if you can’t repay the loan, the plan sponsor will report it as a distribution to the IRS. I STRONGLY ENCOURAGE you to ask this question before you decide to take out a personal loan.

Q: Can I borrow from any type of IRA plan (Roth, SEP, Simple, or Traditional)?
A: NO! The IRS does not allow personal loans from ANY type of IRA.

Q: Can I borrow for the purchase of an investment property or vacation home?
A: You can use the 5 year personal loan option, but investment properties and vacation homes do not qualify as personal residences, and therefore do not qualify for the lengthier personal residence loan.

*First-Time Home Purchases (IRA only)
You may withdraw up to $10,000 from your IRA during your lifetime to pay for qualified acquisition costs for a principal residence without being subject to the 10% early withdrawal penalty if you meet the IRS definition of a “first-time homebuyer”. You are considered a first-time homebuyer if you have not owned a home in the two years preceding the purchase or your principal residence (if married, your spouse must also meet this requirement). This exception applies to costs to purchase your and/or your spouse’s home or a home for your child, grandchild, parent, or grandparent if you or they qualify as a first-time homebuyer. The funds withdrawn from the IRA must be used to pay the acquisition costs by the 120th day after the distribution is received.

Chris Tanner is a Business Development Manager at New Direction Trust Company. Feel free to contact our Business Development team at 877-742-1270 (Ext. 155) or info@ndtco.com.

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