Tap your Roth IRA for a down payment

Gold house on top of arrayed dollar bills

Turning to your Roth IRA for the down payment on a home can be a good move.

Taking money out of any other Individual Retirement Account or your employer's 401(k) plan is not.

We know how difficult it has become to get a mortgage without a substantial down payment.

With much of our savings now tied up in retirement accounts, they're the only place we can turn for that kind of cash.

But with the mortgage crisis battering the stock markets, many retirement plans have lost 30% to 40% of their value over the last year.

If you take out money now, you'll be locking in your losses, have to pay taxes and penalties on many withdrawals and hurt your chances for a secure retirement.

Roth IRAs are the one exception, because, unlike virtually every other kind of retirement plan, all Roth contributions have been fully taxed. (Unlike traditional IRAs, contributions to Roth IRAs are not tax deductible.)

That means you can withdraw however much you've contributed to a Roth IRA, anytime you want, without paying additional taxes or penalties.

Let's say you've put $20,000 into a Roth IRA and invested that money in stocks, bonds or mutual funds. Your account peaked at $50,000 when the markets reached their record highs in October 2007 and is worth only $30,000 today.

The government still considers you to have $20,000 in contributions in the account. All of the losses suffered over the past year are taken out of your earnings.

Every dollar of your contributions that you withdraw can be spent on the down payment. You'll owe no taxes or penalties.

There are three other options for tapping your retirement funds that we don't recommend.

If you're a first-time home buyer, which means you haven't owned a home during the past three years, you can withdraw up to $10,000 from a traditional IRA without penalty.

But contributions to traditional IRAs are tax deductible, which means pretax money is going into your account.

Even if you make a qualified withdrawal for a down payment, it will have to be counted as income on this year's taxes. If you're in the 25% tax bracket, you would have to pay a minimum of $2,500 in federal taxes and perhaps more in state taxes, leaving you with $7,500 to actually spend on a house.

Need more than that to close the deal? You'll pay taxes and a 10% penalty on any amount you withdraw over $10,000 -- at least until you turn 59 1/2 and can start making penalty-free withdrawals.

If, for example, you withdrew $20,000, you'd owe $1,000 in penalties plus $5,000 in taxes (assuming you are in the 25% tax bracket). You'd have $14,000 to spend on your house.

You'll get to keep even less if you make a hardship withdrawal from your employer's 401(k) plan.

As with traditional IRAs, contributions to 401(k) plans are tax-deductible.

As a result, you must pay the same income taxes plus a 10% penalty on all of the money you take out.

Another option would be to borrow the money from your 401(k) plan.

The loans are not subject to federal or state taxes, so every cent is available to spend on your home, and the interest you pay goes back into your 401(k) account.

Here's the problem: These loans must be repaid within five years or immediately if you lose your job.

That's a tremendous risk to take with the economy in a serious recession that could send millions to the unemployment lines.

If you used a 401(k) loan for a down payment and got laid off, you'd have to repay thousands of dollars at a time you'll need every cent you've got to keep up with the payments and avoid foreclosure.

If you can't come up with the money, your loan is reclassified as a hardship withdrawal and you have to pay all the taxes and penalties, which you also can't afford.

That's just too big a risk to take right now.

And finally, there's another big reason to think twice before taking money out of retirement accounts -- even Roth IRAs.

"With a withdrawal ... you lose the opportunity to compound retirement money over time," says David Littell, a professor of taxation at the American College in Bryn Mawr.

"Although it is tempting to buy a house when prices are down ... tapping your retirement plan for a down payment will hurt you too much in the future, especially if you're young."

When you are in your 20s and 30s, retirement funds carry an exceptional power to compound over 30 or 40 years. By siphoning money from those accounts, you lose that compounding effect.

In Littell's view, it makes more sense to gradually save for a down payment from your earnings and put off buying a house. Odds are the housing market hasn't hit bottom, and even when it does, prices are likely to rise modestly for a number of years.

However, it actually makes more sense to tap a retirement account if you're older, because you've already gleaned most of the benefit from compounding.

If you're 50 or over, you can withdraw money from your IRA without penalty by setting up substantially equal payments based on your life expectancy. These payments must last for at least five years.

But before you go that route, check with your tax adviser, because the rules are complex and one mistake could trigger expensive penalties and interest payments.

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