12 Dec Home down payment vs. retirement money

Q. For my daughter’s birthday, I want to give money for an IRA, but she wants to save for a house. How can I convince her that saving for retirement early is better, even though she wants a house sooner?
— Mom

A. You and your daughter are smart to be asking this question and thinking long-term. Both are important goals.

The younger you are when you start contributing to a retirement account, the longer compounding interest will work for you, said Lisa McKnight, a certified financial planner with Lassus Wherley in New Providence.

At the same time, she said, many would like to own a home before they turn a certain age, get married, or have kids and generally, a down payment of 10 to 20 percent is the norm, she said.

“If you must choose between retirement savings and saving for a down payment, we suggest focusing on retirement first,” McKnight said. “Funding retirement will be her largest liability and the one that is the most difficult to fund.”

Once she has a retirement savings plan and gets this under control, then she can concentrate on saving for a house, McKnight said.

In the meantime, she said, your daughter can continue to rent and if you are thinking rent is wasted money, think again.

“Historically, over 20 to 25 years or more, stock market gains have far outpaced real estate, and if you take into account after considering various costs associated with owning and selling a home, the actual return has likely been negative,” McKnight said. “Renting is often a better option for many, especially those with lower marginal tax rates. Buy your house to live in, not as investment.”

If you are looking for retirement vehicles, McKnight said you should look at a Roth IRA.

A Roth IRA allows you to save up to $5,500 post-tax — your daughter is likely in a low income tax bracket and does not need the deduction offered by a traditional IRA — and all future withdrawals are tax-free when you follow the rules, she said.

Ideally, the money in your Roth IRA should be earmarked for retirement. However, some unique features of the Roth IRA allow you to tap the contributions for a down payment on a home if needed.

“Roth IRA rules allow you to take out your original contributions at any time tax-free and penalty free,” McKnight said.

So she could use the Roth IRA as a house savings account with certain stipulations: if the account open for five years, you withdraw $10,000 or less to purchase a home and the funds are used directly toward home acquisition, she said.

“Under these conditions you have a one lifetime limitation and it will be both income tax- and penalty-free,” McKnight said. “You can always take out your principal without penalty or taxes. Just remember to increase your retirement contributions significantly after that, since you’ll have some catching up to do.”

Ideally, McKnight said, your daughter should max out her Roth IRA each year.

“Any additional funds that she can save should then be earmarked towards a down payment,” she said. “To accelerate her down payment saving, especially when rates at savings accounts are so low, she may want to consider opening an investment account and investing some of the savings in the market.”

Just make sure not to take too much risk with the funds as the actual home purchase nears.

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This post was first published in December 2017.