There may be many reasons for using retirement funds to buy a second home. Whether you’re interested in a vacation property on the water or a rental property for investment purposes, buying a second home can be quite compelling. Yet, there are many things to consider before doing so, including the type of retirement plan you are withdrawing from, the tax consequences of withdrawing funds early and the available alternatives. In this article, we explore each of these in turn.
Types of Retirement Plans
Before using retirement funds to buy a second home, you will first need to understand the various types of retirement plans available and the differences between them. Here is a brief overview of the most popular retirement plans in the United States and Canada:
- 401(k): A 401(k) is a retirement plan offered by many companies as a benefit to employees. Generally, an employee can contribute by diverting part of their paycheck into the plan. Many employers will also provide matching contributions as an added bonus. The money in a 401(k) grows tax-free until withdrawn, at which time the account holder will pay income tax on the money taken out.
- Individual Retirement Arrangement or “IRA”. Traditional IRAs are retirement plans that are mostly opened and managed by people themselves. Pretty much anyone with taxable income can contribute to a traditional IRA. For those that don’t have access to an employer’s 401(k), an IRA may be appealing. Tax advantages are similar to a 401(k) where contributions reduce your taxable income and the money grows tax-free until withdrawn. However, there are also important differences between traditional IRAs and 401(k) plans, including the contribution limits.
- Roth IRA. The main difference between a Roth IRA and a traditional IRA is when the tax benefits are realized. With a traditional IRA, your contributions reduce your taxable income but you pay tax when the money is withdrawn. Alternatively, with a Roth IRA taxes are paid on the contributions themselves, but the money can be withdrawn tax-free at retirement. For those individuals that expect to be taxed at a lower rate in retirement, which is the most typical scenario, a Roth IRA may not make the most sense. If the opposite is true, then there may be some benefit to opening a Roth IRA. One of the benefits of a Roth IRA, which is further discussed below, is that early withdrawals are permitted without penalty subject to certain restrictions.
- Registered Retirement Savings Plan or “RRSP”. An RRSP account permits the account holder to contribute a certain amount of money each year while reducing their taxable income based on their contributions. Once withdrawn, tax is payable thereby permitting you to defer taxes until retirement.
- Tax-free Savings Account or “TFSA”. Similar to an RRSP, a TFSA is a registered savings account that can hold savings and investments. But unlike an RRSP, contributions don’t reduce your income. Instead, all amounts in a TFSA are based on after-tax dollars and all income earned in the account is tax-free even after it is withdrawn.
Tax Implications and Other Considerations
The information in this article is provided for information purposes only and does not constitute tax advice. As everyone’s circumstances differ, be sure to speak to a qualified tax advisor.
Now that we have a better understanding of the different types of registered plans, let’s take a closer look at some of the tax implications.
Tax Implications in the US
- 401(k): Generally, if you make any withdrawal prior to the age of 59½, you’ll pay a 10% early withdrawal penalty in addition to income taxes on the amount you withdraw. Withdrawals after the age of 59½, on the other hand, are taxed at your ordinary income tax rate. So age matters. There is an exception, however, where the IRS allows for penalty-free distributions before the age of 59½ in hardship-related circumstances. To qualify, you, your spouse, or a dependent must experience “an immediate and heavy financial need” and the amount you withdraw must be “necessary to satisfy the financial need.” The purchase of a second home would typically not meet this requirement, absent other circumstances.
- IRA: Similar to a 401(k) plan, any withdrawal prior to the age of 59½ will typically be subject to a 10% early withdrawal penalty in addition to income taxes on the amount withdrawn. And while first-time home buyers are allowed to withdraw up to $10,000 without incurring the 10% penalty, this doesn’t apply to a second home.
- Roth IRA: With a Roth IRA, you can take out your contributions (as opposed to earnings) at any time without paying taxes and penalties since it’s after-tax money. As soon as you start withdrawing earnings from the account, the amount is typically treated as taxable income. Further, any withdrawal of such earnings prior to the age of 59½ will typically be subject to a 10% early withdrawal penalty.
In short, unless you’ve reached the age of 59½ and/or you are withdrawing an original contribution amount from a Roth IRA, early withdrawal penalties can be pretty steep.
Tax Implications in Canada
- RRSP: While the Canadian government does permit first-time homebuyers to withdraw up to $35,000 per year from their RRSP to cover the cost of purchasing a home, the program is not available to purchase a second home. Instead, there are a number of taxes and fees for early withdrawal. In addition to income taxes, you’ll also pay withholding taxes of:
- 10% on amounts up to $5,000 (5% in Quebec)
- 20% on amounts over $5,000 up to and including $15,000 (10% in Quebec)
- 30% on amounts over $15,000 (15% in Quebec)
So if your highest marginal tax rate is 31% and you withdraw over $15,000, more than 60% of that amount will be subject to income and withholding taxes. That’s a steep price to pay. Also, keep in mind that you’ll permanently lose your RRSP contribution room following a withdrawal.
- TFSA: One of the benefits of a TFSA is that the amounts invested are after-tax dollars. Thus, you’re free to withdraw funds from your TFSA without penalty. Keep in mind, however, that withdrawals will only be added back to your TFSA contribution room at the beginning of the following year. If you over-contribute, you will be subject to a penalty of 1% of the highest excess TFSA amount in the month, for each month that the excess amount stays in your account.
Even if you’re comfortable with the penalties, most financial experts will advise that withdrawing funds early from a retirement account is generally a bad idea. Not only will you lose the value of tax-free growth from your retirement account, but it may be difficult to catch up. For instance, let’s assume you withdraw $20,000 from your retirement account to buy a vacation home and plan to repay the entire amount back in seven years. Let’s also assume that, before withdrawing the money, you were earning a reasonable 6.00% annual return. Had you left the money alone, in seven years it would have been worth more than $30,000. Instead, you will now need to come up with an additional $10,000 just to catch back up. Yikes! To make matters worse, you likely only saw a fraction of the original $20,000 after paying all of the early taxes and fees.
Alternatives to Using Retirement Funds
Before using retirement funds to buy a second home, consider one of these alternatives:
- 401(k) loan: If permitted, a 401(k) loan may be a better alternative if you need money to buy a second home. That’s because the fees associated with a 401(k) loan are lower than a simple 401(k) withdrawal. While qualified 401(k) loans are penalty free, if you leave your current employer the repayment period accelerates to that year’s tax filing date. If your loan is not repaid by then, the remaining balance is treated as taxable income. Also keep in mind that you typically can’t make new contributions while you’re paying back a 401(k) loan.
- HELOC and other home equity loans: If you have equity built-up in your existing home, then a home equity line of credit or other home equity loan may be the preferred option. In addition to offering flexible financing terms, the cost of borrowing is often lower than a personal loan or other form of unsecured loan.
- Low-down payment mortgage: If you’re struggling to save up for a down payment on a second home and a home equity loan is unavailable, consider whether a low-down payment mortgage is available. In such cases, you may only need 5% to 10% down. Note, however, that most lenders will require 20% or more down on a second home.
- Government tax credits: While not a complete solution, there are certain government programs that provide access to grants and tax credits. For instance, both the United States and Canada have programs in place where environmentally responsible improvements to your home are made and there are many other programs.
- Fractional or shared ownership: Buying a fractional or shared interest in a property is a great way to keep costs down. Whether it’s a timeshare in a sunny beach destination or a family cabin shared with relatives, you can greatly reduce your cost of ownership.
Otherwise, don’t rule out the possibility renting instead of owning if the financial strain of ownership is too great.