Coming up with money for a down payment on a mortgage and consistently making monthly payments are two of the biggest challenges of buying a home. Homeowners who don't have a lot of cash on hand may be tempted to use the funds held within retirement accounts, like IRAs, to pay down a mortgage. Paying off a mortgage early can reduce monthly expenses, but raiding an IRA can result in higher taxes and leave you with fewer resources for retirement.
A traditional IRA offers two basic tax benefits: tax deferral and tax deductible contributions. Tax deferral means you don't pay any tax on investment growth, like interest, dividends or capital gains, until you withdraw the money. Tax deductions on your savings into the account save you money on taxes in the year you make the contributions. Because you have to pay income tax on IRA funds upon withdrawal, withdrawing funds from an IRA to pay down a mortgage increases your income taxes for the year. Withdrawals from a traditional IRA made before the age of 59 1/2 are usually subject to a 10 percent early distribution penalty in addition to the normal income taxes that apply.
Roth IRAs differ from a traditional IRAs in that contributions are not tax deductible. Instead, you have make Roth IRA contributions with after-tax money, but withdrawals are tax-free as long as you are over age 59 1/2 and your account has been open at least 5 years. You can take your original contributions out of a Roth IRA tax- and penalty-free at any age, but withdrawals of investment gains taken before the age of 59 1/2 are subject to income tax and the 10 percent early withdrawal penalty. Using a Roth IRA to pay down a mortgage can result in paying extra taxes, so tread carefully.
Large IRA Withdrawals
One of the main tax advantages of traditional IRAs is that investors may have lower income tax rates during retirement than their careers, allowing for relatively low taxes on withdrawals. Taking a large withdrawal from a traditional IRA in a single year to pay down a mortgage can potentially cause you to move into a higher income tax bracket, increasing the amount of income tax you pay on that withdrawal. Making smaller withdrawals from a traditional IRA over the course of many years tends to minimize taxes.
The purpose of an IRA is to build wealth for retirement and supplement other sources of retirement income. Keeping money in an IRA as long as possible tends to maximize investment growth and the benefit of tax deferral. Taking money out of an IRA to pay down a mortgage may reduce your monthly expenses, but it also shrinks your nest egg so you have less money to withdraw later in life, a time when you may need extra money the most.
- Internal Revenue Service: Topic 451 - Individual Retirement Arrangements (IRAs)
- Internal Revenue Service: Traditional IRAs
- Bankrate.com: Using an IRA for a Down Payment, Tax-Free
- Kiplinger: How To Tap Into an IRA For a Home Purcahse
- Bankrate.com: Don't You Dare Pay Off Mortgage With IRA
- Internal Revenue Service: Roth IRAs
Gregory Hamel has been a writer since September 2008 and has also authored three novels. He has a Bachelor of Arts in economics from St. Olaf College. Hamel maintains a blog focused on massive open online courses and computer programming.