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Roth IRAs allow distributions of up to 10k for "first time home buyers," after they've been open for five years. If you knew you were going to use the money for a downpayment in five years or less, it seems common wisdom that stocks are too risky. But what eligible investments should I be looking at to earn interest and preserve capital?

7

The time horizon is usually very short for a home down payment. I would use Certificates of Deposit (CDs) with a short maturity (in the horizon of your intended use) or Money Market accounts. Depending on what the interests rates are where you are looking.

You don't want the money in the market 100% (i.e. stocks) as the fluctuations might be too wide around the time you intend to pull the money out (and that will be soon).

4

If the time horizon is 5 years, I don't think that playing games with Roth IRAs or investments is really productive. I'd look at an online savings account as a holding place for this money.

EDIT:

Another option is the US is Savings Bonds. The rates earned right now are poor (as of 04/2011 EE bonds earn 0.6% and I bonds yielded 0.37%), and there is an interest penalty if you redeem them in less than five years. But, they are not state taxable, and you can defer tax payments until you cash them.

  • ING Direct looks like its paying 1%, while 30 year US Treasuries are yielding 4.57%. Given the short time horizon, it looks like tax advantage won't help much. But maybe bonds are liquid and safe enough to consider? – jldugger Apr 12 '11 at 16:48
  • @jldugger As hinted at in my Answer, take a look a Money Market accounts. A Money Market account will essentially buy highly liquid securities, like short-term treasuries, and give you the benefits of the higher yield while maintaining your liquidity. – Frazell Thomas Apr 12 '11 at 16:59
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    @jldugger: Typically retail investors don't buy individual treasury bonds (although you can). Investing in treasuries carries interest rate risk -- when interest rates go up (very likely in the next 5 years), the value of your 4.57% bond on the market will drop. US Savings Bonds protect you from this risk, but today they carry a very low interest rate. – duffbeer703 Apr 13 '11 at 11:54
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Since you are looking at preserving the principal, I would recommend laddered CDs and short term treasuries (TIPs/iBonds)

2

Five years is too short to be able to safely invest the money in any productive manner. You're saving, not investing.

Part of the problem is that you don't have all the money right now, and you'll need to add to it over the next few years until you have enough for a down payment. See the notes under CDs and bonds below for why this is a problem.

The universe of options:

  • high yield savings account or "rewards checking" -- you'll get 1.00-1.25% max. This is the best (and maybe only practical) option.
  • CDs -- if you're willing to tie up money for three years, you could get 1.8%. But you don't have all the money now, so what are you going to do with the additional savings you have a year from now? Some CD accounts might let you add to principal, but otherwise see high yield savings above. Beware of the penalty for withdrawing early -- if this happens you would have been better off with the savings account.
  • short term US treasuries -- the 5yr currently yields around 2-2.25%. But you have the same problem as with CDs, and there is no mechanism to "add principal" here. And 3yr or shorter bonds have yields that are lower than the high yield savings accounts. There may be tax savings, but the hassle and extra risk doesn't seem worth it. If rates rise and you have to sell before maturity then you will lose principal.

As for the Roth, as duffbeer703 said, I'm not sure it's worth the hassle and risk that you'll want the money sooner and be forced to wait. (E.g. you end up with enough money in 4.25 years for a house that you want but you have to wait 9 months to be able to tap the Roth.) As noted above, the yields are so low that the losses to taxes aren't really going to amount to much. On $10k you're looking at $150 max earnings, and losing maybe $40 of it to taxes (annually). So avoiding taxes won't shrink your time horizon by any meaningful amount.

I'd just open a high yield savings account and start dumping money in. Keep an eye on shorter term (1yr) CD rates and if they go above the savings yield and the timing is right then take advantage of it.

  • Why would short term CDs be a problem? Why would he need to add to the principal? He can have multiple CDs with staggered maturity dates. Putting money in over time is far better than all at once. – Frazell Thomas Apr 13 '11 at 21:24
  • @Frazell: You're right. But short term rates right now are less than savings account rates. This is why I mentioned keeping an eye on CD rates but just putting money into the savings account. Currently the bump in yields is only worthwhile starting at a 3yr term (at least based on my quick search). – bstpierre Apr 14 '11 at 1:46

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