Help a Reader: Withdrawing from a Traditional IRA

Here's an email I recently received from a reader:

My wife and I are looking at buying a home in the next year. We have about $30K equity in our current home. With the new $6500 tax credit for homeowners who have owned their home for 5+ years it has peaked our interest and our family is growing. We are looking for a home in the 200K - 275K price range.
 
I have a Traditional IRA that is worth about 28K. This was from a 401K rollover from a previous job. I have not put any money into it for the last 2 years. Both my wife and I have Roth IRAs and I have current 401K that has an excellent match in all we have about 50K in retirement right now. I am 34 and she is 32, so we both feel like we have several years before we "retire".
 
I guess my question is, is it worth it to take the penalty of withdrawing my Traditional IRA to use as part of a down payment on a home? The penalty I pay will be offset by the $6500 tax credit. Prices of houses in our area are at a low, so I feel like we are investing the money into a house we plan on having our kids grow up in.
 
I make about 75K a year and my wife makes about 20K a year part time. We have no debt other than our house right now.

What's your advice for him?

Comments

[Roy]

I would not use the traditional IRA, but I would consider using the the contributions part of the Roths IRA's if penalty free, then make sure the home I bought ended up with Mortgage payment, property tax, and home owners insurance premium totaling no more than 25 percent of the primary wage earners salary if that job and salary is secure.
It doesn't make sense to me to spend extra to get the incentive. I would sooner buy something I have money available for and use the incentive and then move up at a later time when more equity is built if a nicer home was still my goal.

[Infinion]

That seems like an expensive house for their income level, especially since maybe 20K of that might be a little unstable (part time). Maybe it's just the locality though. There's no mention of any other reason to move. They don't say their current house is too small, or falling apart, or they can't afford it, or they hate the commute to work. Their reasons are just to move up with the Johnsons and get that $6500, which is silly, because if their current house is worth anything above $100K, they'll love that $6500 in sales charges anyway. Cashing out the IRA wouldn't be a terrible idea IF it was their first home, and they needed it now. There's not good reason to pay such a large penalty for something they don't need. What they DO NEED, is to keep everything they've got in their retirement account. Even considering there was a recent downturn in the economy, at an average as of 33 years, their 50K in retirement is pretty lousy really. They could be in big trouble at retirement. They need to step up their 'investments' into real investments like retirement accounts and low cost stable mutual funds instead of a larger house for no reason.

[sashie]

I don't understand where their money is going based upon the details given. They should be easily able to save 28K in one year from regular paychecks if they are serious about saving and leave the IRA alone. And if they can't save that 28K in a year, well, personally I think they need to reconsider whether they can really afford a more expensive house.

[[email protected]]

Jeez, I didn't even realize that there was a "$6500 tax credit" for existing homeowners!

All I have to say is be careful. I know more than 1 family, that have been trying to sell their existing home for the last 4 months. Every month that it doesn't sell, that's an extra mortgage payment (not to mention utility costs) coming out of your pocket...

[Holly]

Take it from someone who was in almost the same exact situation...moving is VERY expensive. Unless you have the perfect realtor, the paerfect broker/bank to work with, the perfect location, the perfect properties, and even the perfect family and friends to help with the move, expenses when selling your home will be enormous.

Transfer taxes, closing costs, real estate commissions, and a WHOLE host of other fees (i.e., our hot water heater failed 2 days before closing and we had to have our electrical system upgraded due to a recall on the box) will be enough to make you wish you had never even considered moving. If you're able to stay in your current home and build up a LOT of equity and savings, I would definitely stay put.

And remember to put things in perspective -- children only get more expensive as they grow older (braces, auto insurance, sports clubs, food and clothes, private school, college, weddings, etc.!). The bottom line is that you will appreciate your bottom line in the future and be the envy of those whose expenses are through the roof.

[Holly]

Sorry for the 'rant', everyone (above).

I just want to impress upon the readers who write in for financial advice that they can learn from others and be content in their decision knowing that hindsight is 20/20. Once it's done (the move), it can't be easily undone.

Every situation is different, but I barely go a day or two without wishing I had been given solid advice from someone who cared for us or had first-hand knowledge of the details. We would have a brighter and less stressful financial future if only someone had opened our eyes.

[BillV]

I have to agree with those above me. Unless there is some compelling reason not mentioned in the original post; leave the IRA alone. Find another way to borrow the money, or save up the 28k during the next year, or stay put. Don't overlook what Holly has said. Moving is always more expensive than you think.

[Apex]

Don't tap the IRA.
Don't tap the Roth (you can't put it back after you take it)
Consider not moving at all.
But if you do, find another way. The $6500 credit is not worth it unless everything else makes sense. If you decide to move to get the credit, use your current equity (if its truly there, you won't know until you try to sell), buy a house with less down and save like crazy over the next year, pay down the mortgage and get it re-appraised in a few years to get out of PMI. If you aren't able to save at that rate and make that happen, then you are buying too much house and should call the whole thing off.

[Old Limey]

At your age it's STUPID to take money out of your IRA.
If you have to move to another house do it with other money.

You also need to think about how secure your employment is. That should be your overriding concern right now. This country is a long way from being out of the woods and if you were to lose your job soon after selling one home, buying another, and taking on a larger mortgage you would be up the creek without a paddle, and with young children that's not a place that you ever want to be.
This is a time to hunker down, play it safe, and have what it takes to weather a big storm that could slam right into you. There's no better feeling, especially as a parent, than knowing that you can take a big hit without it turning into a calamity of the type you read about in the newspapers all the time.

[BillV]

Btw, I could not tell from the post whether or not you have 50k in your retirement plus the 28k in the IRA. BUT. In either case, unless you also have a defined benefit contribution pension plan and a good one, you are a long way from being on track in terms of funding your retirement. And it has to cover both of you.

Your wife is currently working part time. You say making almost 20k. I read that as she is probably closer to 18k. When you start your family, will she go back to work? If she does not--deduct her income whatever it is. You will be living on your salary only ,plus one more person to feed, cloth, and care for. A child is going to increase your costs by more "merely" one third. Hopefully you work for a company that provides health care. However, it is likely that your monthly contribution will go up because of the extra dependent. You have checked into that, right. Do you have life insurance? Will it provide for two?

If she plans to go back to work, you will need to pay for child care. (unless family will do it for free). Even so, assume she stays home for three months after delivery. At 20k per year you will lose about 5k so she will only earn about 15k.

Were you using any of her money to fund your retirement? Say good bye to that. And not to rain to hard on your plans, but, did you have any plan to start a college fund? Not that that is a requirement, just asking.

Unless you have money or circumstances not mentioned in your post. Increase your savings and rethink the price range of your new house. It seems to me you should only be looking at housing you can afford on your salary alone.

[AM]

Thanks for the comments everyone. I am the person who sent in the original question. I appreciate all of the what ifs? My wife and I are financially fine. We have a nice rainy day fund, life insurance, college funds, etc. After reading the comments, you are right on many fronts. We do need to save more for retirement and yes we can probably find the money elsewhere. The basic question was tapping an IRA when the tax penalty will be close to the $6500 and get out of paying PMI and afterall not having a mortgage when we retire. We "need" a bigger home since we already have a 2 year old and one on the way. We live in a small house that we have just outgrown. We are lucky that my wife can work from home and watch the kids. Bottom line is yes we can do more, and you all have answered my question. Don't touch the IRA, save more, and hunker down for a couple of years. God Bless all of you!

[BillV]

To FMF:
Another satisfied customer uhmm reader.
; -)

[Old Limey]

Sometimes when you are in doubt it really helps to throw your ideas out to the world and see what other people have to say. I think AM received some good advice that had a lot of unanimity to it.

There was a somewhat related subject on NPR topics the other day, in fact it's still there. In that case the family home was "under water" and the major breadwinner had just lost his job, but found another similar job 660 miles away in another state. Their solution was to have the wife keep her teaching job and stay in the home with two teenagers while the husband was flying home every other weekend and paying rent. The problem was that his new employer was temporarily subsidizing his rent, and when the subsidy ended they would not be able to afford both the mortgage and the husband's rent.
Not a good lifestyle for any family but unfortunately it's happening a lot now that the "Real" unemployment rate is 17.3%, the 10% number excludes lots of others for a variety of reasons and all forecasts point to a job recovery that could take many years.

[DCS]

OK brevity isn't my strong point so sorry about the length of this. Also, it looks like the decision is made already, but maybe this will help someone else.

First, be aware that right now you need to have a binding contract signed by April 30th to get the credit. The problem? For me at least that would mean the current house would have to definitely be sold by the time I sign a contract for a new house. Dad was in real estate for a while, and I've seen lots of deals that have a binding contract fail to complete on some contingency in that contract - everything from financing falling through, to inspection problems, to title issues. Not to mention if they're not first time buyers, they could make it contingent on selling THEIR house.

I wouldn't want to sign on a new house until the contract on the old one was completed. Do you have time to complete sale on the old one AND locate a new one and get a binding contract on it by April 30th? That's less than four months. And it's a very slow market. And the new rules for financing require a very complex, cumbersome, and time-consuming appraisal process if your buyer is financing. You might be cutting it close even if you had an accepted offer today. If you can't close your house by 4/30, you could end up with two payments (in a bad market, too), which would quickly eat up that $6500 credit and more.

Second, in saying that the credit will offset the penalty, remember that you can't put that back in the IRA. So unless you make it up in, say, your 401(k) you can never make up the tax-deferred earnings that those $28K would have earned in 30+ years. Huge opportunity cost there, and the IRS 401k limits would mean that, depending on how much you already contribute, making that up would take years.

If you do decide to buy a new house, and the main reason you're cashing in the IRA is to avoid PMI, consider this: PMI is not a huge expense, at least not where I live. Mine is $60/mo (my loan was for about $120k). Also, PMI must be canceled as soon as you reach 20% equity on the original sale price by federal law. So, if you have the income for it, instead of trying to make up the value of the IRA in 401k over many years (or not make it up at all), use that money to pay down the principal on the mortgage until PMI is canceled. During that time, I believe the PMI will still be deductible. Not a reason to get it, but at least a slight break on the total cost.

I also wouldn't let the incentive rush you, or make it the determining factor. I did that on the Cash for Clunkers (I had no intention of buying a new car until C for C). The rebate was nice, and the car prices were very, very low with incentives. I think it was a good deal, I was in a position to buy, and I like the car just fine - but I often wonder if I should have let that $3500 influence me. Compared to a home, that car is a relatively small investment.

If you're ready to move, then go ahead and start looking and maybe list your house. Forget about the credit. If you get it, great! But don't make it the reason you move. You'll feel rushed and might compromise on something you shouldn't, or miss one of those great deals that come along to the patient, and that savings could be a lot more than $6500. On a $200,000 house, $6500 is a whopping 3% discount. Even just looking at $28,000 from the IRA as a down payment, $6500 is only about 23%. Is a compromise home worth a <25% discount? Time and time again I've easily saved more than 25% just by waiting around for the right deal to come along, and being in a position to take advantage quickly. Having a deadline is a well-known weakness in negotiations. It costs money and forces you to lower your standards. Don't let loss aversion magnify a small incentive into a major factor in your decision. It could cost you way more than the IRA withdrawl penalty.

[Christine]

Do not touch your retirement accounts. Do not buy a house right now. Frankly, I would sell the house, put the $30,000 toward my underfunded retirement, and rent a bigger place.

But, if owning is what you want to do... the fastest, easiest, and most responsible way to get that down payment ready is to stay in your current house, banking the difference between your current housing costs and your future housing costs.

If you have to have a bigger place RIGHT NOW, try to rent one for less than the mortgage+ins+tax payment of a comparable place. If 3-BD homes in your area go for $1,200 or less, it's possible, particularly if it comes with heat/cooking gas included. Bank the difference. Rent the current house for profit if possible, also banking that cash. You should be able to offset costs of the new baby, throw more into retirement, and remain a "homeowner", yet have a bigger place.

[jeffinwesternwa]

worth penalty PLUS taxes = NO. House market is SLOW in most of US, get the price reduced or find another property. Jobs are hard but, can you work a 2nd job (either of you) or get overtime? Mom and Dad loan or gift? Folks don't ralize in post pension era how MUCH $$ are needed in retirement for today's work force. those in 20's-40's are way behind and won't be comfortable like today's retired middle class w/o much more sacrifice. Don't think a million, more like $2M! you need AT LEAST 15% of gross pay if not more to retire at 67~ even with 2 social security checks. REtirement $$ (and no consumer debt of course) IS JOB 1!

[beverly]

i always find it funny when people have a little bitty baby and think they need a bigger house. may i suggest that youre not outgrowing your house because theyre too many people living in it, but because you probably have too much STUFF in it. declutter, declutter, declutter!

[Marc]

What is the penalty on withdrawing from an IRA? 10%. You pay that now. Assuming a $25000 withdrawal and plugging the numbers into a TVM analysis, it only makes sense if you need over 5 years to come up with the money. If you only need 2 years, it is equivalent to paying 33% interest and in that just put it on a credit card - you would be better off.

[Evan]

Maybe I didn't read the comments close enough, but everyone seems to be missing a huge point:

"Both my wife and I have Roth IRAs and I have current 401K that has an excellent match in all we have about 50K in retirement right now."

You have a current 401(k) - You COULD (not sure I would recommend it per the great comments above) take a loan from it...so no penalities and it is at a lower rate than your mortgage in most cases.

More info would be needed but that is an option.