Pros and cons of using a Roth IRA to fund home improvements

Question

I have a Roth IRA with a balance of something like $150k. Say around $100k of that is contributions. Due to my income, I am ineligible to contribute to the Roth IRA, but I do maximize contributions to my 401(k) and traditional IRA. I also invest "extra" income in a brokerage account, but only have a ~$5k balance at present. I have something like 25 to 30 years remaining until I retire (no pension income). I am securely employed and believe it is very unlikely that I will lose my job or experience reduced income at any point prior to my retirement.

I'd like to make some home improvements to modernize my ~50-year-old house (my primary residence). I have something like $30k in cash in various accounts. I'd expect the cost of home improvements to be something like $60k (have not yet gotten any estimates, but figure that's a reasonable ballpark figure). I'd like to avoid spending cash on this in the unlikely event I lose my income or experience an emergency of some kind.

I have no intentions of selling in the near future. I'm quite happy with my home, throwback to the '70s aside. I'd just like to make the improvements for my own personal satisfaction and contentment with my property.

I have a recently (Dec-2020) refinanced 15-year mortgage at a low rate. A cash-out refinance would have been a way to get the cash to support this, but I decided against it. Loan-to-value ratio is something like 50% on the property. No other liens on the property.

I am mulling over withdrawing from my Roth IRA contributions to cover these home improvements. I realize I cannot ever replace this money in my IRA (since I already max out traditional IRA contributions), but am weighing simply "paying it back" in brokerage account investments.

I figure I can get a home equity loan at something like 7% to 8%, but am having trouble justifying why it wouldn't make sense to withdraw IRA money instead of getting a loan when I'm in a position to easily "pay it back" anyway. The total value of all my retirement accounts is something like $500k.

What are the pros and cons of this approach, or are there other more cost-efficient ways to get money to support these home improvements? I do itemize deductions in case that's a relevant consideration.

I am aware of all the bits and pieces, like capital gains taxes, investment return rates, interest rates, etc., but am having trouble putting them all together since it seems to me that there are too many variables and big numbers to determine the big picture within an acceptable degree of accuracy.

I'm open to any recommendations or viewpoints you have to share.

Answer 1

Typically you'd have to wait 6-months to do a cash-out refinance after your last refinance. You already itemize so if you can refinance to ~3% with 60k cash-out your effective interest rate on the renovation loan would be in the 2.05-2.28% range (I'm assuming you're in the 24% or 32% bracket). If you can't refinance with lender credit covering closing costs then you'd have to re-factor your effective rate incorporating those costs. This option can be nice due to the lower rates and flexibility since you can decide monthly how much extra to pay towards the mortgage.

Either a HELOC or Home Equity Loan would be in the low-mid 5's last I checked. HELOC would be variable rate most likely though there are some hybrid options. Interest would be deductible on either since used for renovations, so effective rate maybe in the 3.6-4.1% range.

Effective rates above could be even lower depending on how your state handles income tax and depending on your actual income tax bracket.

Meanwhile, the Roth IRA is hopefully earning at least a few percent per year and the gains are tax-free. Your replacement/payback investments would need to outperform the Roth IRA by enough to make up for the extra tax liability you'll incur down the road and the years of growth/compounding you miss out on.

To approach a reasonable calculation you'd have to estimate both future tax rates and investment gains and you'd need to calculate effective interest rates on each financing option using actual rates and adjusting based on federal/state interest deduction benefit. Some people are concerned about rising inflation rates, so that could also be factored in.

Since you will get full benefit from interest deduction on any of the home equity financing options and since Roth IRA gains are tax-free I would be surprised if financing the renovation were not the best option. It's not certain, if the market performs poorly over the next few years then taking the Roth IRA money out could have been the better option. Ultimately this depends on your investment outlook.

Don't discount your comfort level for risk/debt. If you feel better having less debt and less money exposed to market risk, that is perfectly reasonable even if it doesn't end up being optimal financially. Some good news here is that it sounds like you are in a decent situation and which option you choose is unlikely to cause you regret or ruin.

Answer 2

How about getting a 401k loan for $50k, and then get the rest from "cash in various accounts."