New house; 401k to IRA to avoid penalty

[Possi]

My client purchasing a new home was advised to take an old 401k from a company she no longer works for, convert it to an IRA, and use the distribution to put down on her house... all to avoid the early-distribution penalty.

I told her there might be a "time" rule hidden someplace...

Is this a good tax strategy? Or is it not?

[erchess]

Time

I think I would ask the trustee of the potential IRA whether there is any problem with this. If I were the trustee there would be a substantial penalty payable to me if anything like half of a new account was withdrawn unless as well may be the case such a penalty would be illegal. One thing I know is that if I were the trustee your client would be on a short list of people I wanted to hurt any time I reasonably could.

[DaveinTexas]

This is possible

My client purchasing a new home was advised to take an old 401k from a company she no longer works for, convert it to an IRA, and use the distribution to put down on her house... all to avoid the early-distribution penalty.

I told her there might be a "time" rule hidden someplace...

Is this a good tax strategy? Or is it not?

But the penalty can only be avoided on up to $10,000 of the IRA withdrawal and the client will have only 120 days after the withdrawal to purchase the home.

A good tax strategy if it is worth the trouble (direct rollover, etc) to save $1,000 in additional taxes; an instructor told us a few years ago this wasn't a penalty but an additional tax (semantics).

[S T]

If this could meet the requirements 401K rollover to IRA and then a distribution see http://www.irs.gov/Retirement-Plans/...th-Conversions also go to Tax on Early Distribution link for IRS chart

For Distribution from an IRA to purchase first home - to avoid a penalty for early withdrawal - the limit is up to to $ 10,000

See TTB page 13-2 chart for Exceptions to Penalty - Code 09 72(t)(2)(F)

[Roberts]

My client purchasing a new home was advised to take an old 401k from a company she no longer works for, convert it to an IRA, and use the distribution to put down on her house... all to avoid the early-distribution penalty.

I told her there might be a "time" rule hidden someplace...

Is this a good tax strategy? Or is it not?

Does this purchase qualify as a first home purchase?
Whether it makes good financial sense is very questionable but it can be perfectly reasonable for tax purposes.

That $10k limit is PER PERSON. If they are married, both spouses can utilize the $10k limit and come up with $20k. They'll have to pay tax on the distribution though.

[Possi]

Per person?

Does this purchase qualify as a first home purchase?
Whether it makes good financial sense is very questionable but it can be perfectly reasonable for tax purposes.

That $10k limit is PER PERSON. If they are married, both spouses can utilize the $10k limit and come up with $20k. They'll have to pay tax on the distribution though.

Is that per-person, no matter who owns the account? If so, it would save $2k in penalties. That's a great strategy. (Except that they are spending retirement money, of course)

[JohnH]

Well, are they really "spending" retirement money?
IF they have done their homework and the price is a good value, then one could make the case that they have shifted the asset "Cash" in the Asset "Real Estate". So it's really a sideways move (minus the tax haircut), essentially changing the bucket in which the retirement money is being held. Since their home equity is the largest retirement asset many people own, it is technically still in a retirement account by a different name. Provided, of course, they don't decide to borrow it back out in the future with a refi or HELOC and then pour the money down a rathole by buying a motorcycle or boat.

Whether it's a smart move will only truly be known when they sell the house or die, but that's also true of any mutual fund or stock in which the money sits at the moment. So if they forego the tax-free earnings which the money would gain them where it sits, and at the same time they save as much or more in interest payments (net of the tax deduction), plus possibly realizing some non-taxable long term gain in the value of the home, it might be the smartest place to park the $10K / $20K. It all depends upon facts & circumstances, and upon future results which cannot be known.

I've seen people do worse, even savy investors.

[Possi]

Newlyweds

I just realized that this is not her first home, but it is her husband's first new home.

Great analysis, JohnH. So many facets to consider.

[Roberts]

I just realized that this is not her first home, but it is her husband's first new home.

Great analysis, JohnH. So many facets to consider.

They had better not own it jointly if it doesn't qualify as her first home. BOTH have to qualify if owned jointly. Just because it isn't her first home doesn't mean she doesn't qualify as a first time home buyer.

A home you live in shouldn't be considered an investment. I know most people consider it as such but under the classic (normal) definition, it's not an investment. If it doesn't have the potential to spin off cash flow, it's not an investment - it's speculation. Turning it into rental property would be making it an investment.

[Roberts]

Is that per-person, no matter who owns the account? If so, it would save $2k in penalties. That's a great strategy. (Except that they are spending retirement money, of course)

per person - as in per person who has their own IRA.

[mactoolsix]

I just realized that this is not her first home, but it is her husband's first new home.

Here's the "First-time home-buyer" definition: Generally, you are a first-time homebuyer if you had no present interest in a main home during the 2-year period ending on the date of acquisition of the home which the distribution is being used to buy, build, or rebuild. If you are married, your spouse must also meet this no-ownership requirement.

Mike

[JohnH]

I agree with you on the tax issues.

But I guess I'll have to press you a little bit on the definition of an investment.
Maybe the classical definition of an investment is influenced by some sort of industry bias.
Would you consider Berkshire Hathaway "B" shares an investment?

Warren Buffet states up front that they won't pay dividends, so it has zero potential to spin off cash flow. By reinvesting all potential dividends back into the company, the value of the shares increases if management is doing their job. And if I want to pull some income out, I sell appreciated shares.

So I get to control the timing of the income and also get capital gains treatment. If that qualifies as an investment, then the identical situation occurs with owned real estate (regardless of whether it's rental property or a main home).

It isn't as liquid as other investments, and it can't usually be sold in increments, but liquidity is a separate issue.

[Bees Knees]

A home you live in shouldn't be considered an investment. I know most people consider it as such but under the classic (normal) definition, it's not an investment. If it doesn't have the potential to spin off cash flow, it's not an investment - it's speculation. Turning it into rental property would be making it an investment.

There are several reasons why owning a home is in fact an investment:

1) Mortgage interest and real estate taxes are tax deductible. The equivalent cost of paying rent to live in a home is not tax deductible. Therefore, cash flow is in fact increased by paying less tax for owning a home, unless you consider being homeless as an option.

2) Some home owners use low mortgage interest rates to borrow funds that can be invested at higher rates of return. Although this is risky, it is a legitimate investment strategy that can only be achieved by home ownership, as opposed to paying rent to live in a home.

3) As principal is being paid down on the mortgage, equity in the home grows, allowing the homeowner to recover the cost of living in a home when it is later sold. You can't recover any equity when you pay rent to live in your home. Thus, cash flow increases when equity in an old home makes the cost of living in a new home cheaper.

4) For homeowners who live long term in their home, the mortgage is eventually paid off. Living in a home with no mortgage is far cheaper than paying rent to live in a home. Thus, retirement age homeowners smart enough to pay down their mortgage prior to retirement can live much cheaper allowing the cash flow from other investments to go farther.

5) A retired homeowner with equity built up in the home can get a reverse mortgage and have a guaranteed cash flow for the rest of their life, turning their home into a defined benefit retirement plan.

I'm sure there are more reasons why home ownership is in fact an investment in the traditional sense of the term.

[Roberts]

Would you consider Berkshire Hathaway "B" shares an investment?

Just because they don't pay a dividend today doesn't mean they wont in the future. (your example is a case study in virtually every Investment 101 class ever given)

Technically, the value of any investment SHOULD be the net present value of all future cash flows discounted by a required IRR. Since a house you live in likely offers no potential for future cash flow (some people do rent out rooms), it is purely a speculative purchase that the value will increase. If anything, a house is an investment in reduced future expenses but even that is limited. A house requires substantial further investment or in 30 years it'll only be worth the value of the underlying land.

When you add maintenance, rehabilitation, insurance and taxes - it's easy for many parts of the country to pay 4-6% per year to own a home / condo and simply maintain its value. Technically - you NEVER own a house. You only rent it from the state / county / city. Try stop making your tax payments on the property and see how long you "own" it.

Having said all this, I own my house, it's paid off (essentially) and I own rental property. I consider my house a prepayment of some future rent. Rental property is a quality investment in today's market IMO.

[Bees Knees]

Another observation over the years: We all have those poor retired clients living on Social Security and a small pension. For all practical purposes, their income is below the poverty level. They continue to live and put food on the table, not because of some government food stamps or welfare checks, but because their home was paid off years ago. It takes very little income to cover the cost of living. Those with similar retirement funds who have rented their entire life are in much worse shape, usually forced into some kind of government subsidized housing.