Dear Dr. Don,
I’m 28, employed and preparing for the next step in life. Primarily, I want to begin saving for a future home and family. Here’s what I’ve done so far: I have a Roth individual retirement account that has a $1,800 balance, and I plan to invest another $1,800 this year. I also have a 401(k) plan with a $23,000 balance. And I have an extra $550 left over every month that I’d like to invest. Where should I put this money? Should I deposit it into my IRA, my 401(k) or another savings account for my house?
— K.B. Bungalow
First, make sure you’re contributing enough to your 401(k) so you’re receiving the maximum company-matching contribution.
Then, take a look at your Roth IRA. A first-time homebuyer can take out up to $10,000 from a Roth IRA with no penalty tax on the distribution. However, your account must be “seasoned,” or established for five years, before you can take money out as a qualified distribution.
Roth IRAs are funded with after-tax dollars, so you won’t owe income tax or penalty tax on the distribution of contributions. It’s the distribution or investment earnings that may trigger income taxes and a penalty tax if the account isn’t seasoned. Figure 2-1 in Internal Revenue Service Publication 590 is a flow chart you can use to walk you through the tax implications of any early distribution.
If you meet the account-seasoning requirement for the Roth IRA, you could channel the $550 per month into that account up to the annual contribution limit of $5,000. Even with your existing balance of $1,800, it would take more than two years to reach the $10,000 limit for the first-time homebuyer’s exemption.
If you have any money left after investing in your 401(k) and Roth IRA, I suggest depositing the money into a taxable account. The sooner you expect to buy that first house, the less risk you should take in investing this money. A high-yield savings account could be your best choice with a planned purchase within the next two to three years.
Also, when buying a home, please consider a Federal Housing Administration loan versus a conventional mortgage. You can get an FHA loan with a 3.5 percent down payment — well below a conventional mortgage. If you expect housing prices to recover in your market, then you could save thousands of dollars if you buy a home soon.
While many 401(k) plans let you borrow against them for a down payment, the loans become immediately payable should you leave that company’s employment. You can’t withdraw the money to use as a down payment, so it’s not the preferred vehicle for saving for a down payment.
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