Investment retirement accounts (IRAs) are supposed to be sacrosanct. Because they're intended to help you save for retirement, the Internal Revenue Service (IRS) doesn't want you to withdraw any funds from them before you turn 59½. And to enforce that, you'll owe a 10% penalty on the amount you withdraw early, along with income taxes.
Still, every rule has its exceptions. It's possible to use funds from an IRA, penalty-free, to buy a house, even if you aren’t six months away from your 60th birthday. The rules differ depending on which type of IRA you have, though. Here are your options.
- You can withdraw money from an IRA to help with a home purchase.
- In certain situations, you can avoid paying taxes and an early penalty fee.
- If you use funds from your IRA, you’ll lose out on years of compounding tax-free growth—so think twice before you do it.
Who Qualifies for the IRA Exemption?
To use money in your IRA to buy a house, you must be a first-time homebuyer. The Internal Revenue Service (IRS) defines that status rather loosely. You are considered a first-timer if you (and your spouse, if you have one) haven't owned a home at any point during the last two years.
So even if you owned a principal residence at some point in the past—say, five years ago—you may well meet the first-time-buyer requirement. The key word, by the way, is principal. If you've owned a vacation home or taken part in a timeshare during the last two years, the exemption can still apply.
Since IRAs are individual retirement accounts, your spouse can also withdraw up to $10,000 from an IRA.
Also, you don’t have to be the one shopping around. You can tap into your IRA and qualify for the exemption if the money is to help an eligible child, grandchild, or parent buy a home. And that's even if you're a homeowner now.
The Traditional IRA Exemption
If you qualify as a first-time homebuyer, you can withdraw up to $10,000 from your traditional IRA and use the money to buy, build, or rebuild a home.
Even though you'll avoid the 10% early withdrawal penalty on the money, you'll still owe income tax on any amount you—and your spouse—withdraw. Also, that $10,000 is a lifetime limit. You won't get to use the first-time homebuyer provision again to buy a home, even if you use a different IRA.
The Roth IRA Exemption
The rules are different for a Roth IRA. A factor here is how long you’ve had the account. First of all, you can withdraw a sum equal to the contributions you’ve made to your Roth IRA tax- and penalty-free at any time, for any reason, as long as you have held the account for at least five years. This is because you’ve already paid taxes on the contributions.
Once you've exhausted your contributions, you can withdraw up to $10,000 of the account’s earnings or money converted from another account—without paying a 10% penalty—for a first-time home purchase.
If it's been fewer than five years since you first contributed to a Roth IRA, you'll owe income tax on the earnings. This rule, though, doesn't apply to any converted funds. But if you’ve had the Roth IRA for at least five years, the withdrawn earnings are both tax- and penalty-free.
Another option is to open—or convert your existing IRA into—a self-directed IRA, or SDIRA. These are specialized IRAs that give you complete control over the investments in the account.
SDIRAs allow you to invest in a wider variety of investments than standard IRAs—everything from limited liability companies (LLCs) and franchises to precious metals and real estate. And don't forget, the term real estate doesn’t refer only to property. You can invest in vacant lots, parking lots, mobile homes, apartments, multifamily buildings, and boat slips.
The big catch: If you buy real estate purchased with funds from an SDIRA, it must be an arm’s length transaction. It can’t benefit you or your family including your spouse, parents, grandparents, children, and fiduciaries.
In other words, you (and most of your relatives) can't live in the home, use it as a vacation property, or otherwise personally benefit from it. As the SDIRA—not you—owns the home, using personal funds or even your time (sweat equity) to benefit the property is prohibited.
"There are many ways you can use your self-directed IRA to purchase real estate inside your IRA," says Kirk Chisholm, wealth manager at Innovative Advisory Group. "You could buy a rental property, use your IRA as a bank and loan money to someone backed by real estate (i.e., a mortgage), you can purchase tax liens, buy farmland, and more. As long as you are investing in real estate [that's] not for personal use, you can use your IRA to make that purchase."
Thus, the SDIRA option works mainly for an investment property—a house or an apartment you want to rent out for income. All the money that goes into or comes out of the property has to come from or go back into the SDIRA.
However, once you turn 59½, you can start withdrawing assets from your SDIRA. You can then live in the home, as it will have become your personal property after the distribution.
Is Using an IRA to Buy a Home a Good Idea?
Even though you can withdraw funds from your IRA for a home purchase, the question is, should you?
Unless you specifically opened the IRA to set money aside for a home purchase, you should consider other funding options. If you wipe out your initial investments today, it can set back your retirement savings by many years.
There's only so much you can save in an IRA each year. For the 2020 and 2021 tax years, that's $6,000, or $7,000 if you're 50 or older. You can't repay the funds you take from your IRA. Once you withdraw money, it's gone. And you lose out on years of compounding.
If you have other options to help you come up with the down payment, consider them first.
Tap Your 401(k) Instead
If you have an employer-sponsored 401(k) plan, you might think about taking a loan from that account instead of withdrawing money from your IRA. In general, you can borrow up to 50% of your 401(k) balance—up to a maximum of $50,000—for any reason without incurring taxes or penalties.
You’ll pay interest on the loan, typically the prime rate plus one or two percentage points, which will go back into your 401(k) account. In most cases, you have to repay the loan within five years. But if you're using the money for a house, the repayment schedule may be extended to as many as 15 years.
A couple of things to keep in mind: "You will have to include the payments in your monthly budget," says Peter J. Creedon, CFP,® ChFC,® CLU,® and CEO of Crystal Brook Advisors. "Also, the interest you are charged for the 401(k) loan may not be tax-deductible (check with your tax advisor) and will probably be higher than current mortgage rates."
In most cases, you repay the loan through automatic paycheck deductions. This sounds easy enough, but it’s important to understand what happens if you miss payments.
If it’s been longer than 90 days since you’ve made a payment, the remaining balance will be considered a distribution and will be taxed as income. And if you’re under age 59½, you’ll also owe a 10% penalty.
Another caveat: If you leave your job (or are let go), you’ll have to repay the entire loan balance within 60 to 90 days. Otherwise, the balance will be taxed, and you’ll owe the 10% early withdrawal penalty—unless you're age 55 or older when you leave your job.
The IRA Rollover
Consider this: Instead of withdrawing the money from your IRA, borrow it.
Technically, you can't take a loan from a traditional or Roth IRA, but you can access money for a 60-day period through what's called a "tax-free rollover"—as long as you put the money back into the IRA (whether the one you made the withdrawal from or another one) within 60 days. If you don't, penalties and income taxes—including state taxes—are imposed.
This is mainly a short-term solution to a specific problem. For example, "Some first-time homebuyers may want to have a substantial down payment to avoid [having to take out] private mortgage insurance," says Marguerita M. Cheng, CFP,® CEO of Blue Ocean Global Wealth. The tax-free rollover might be "the most efficient way to access funds for the down payment," qualify for better financing and thus clinch the home purchase.
In terms of timing, if you want to take advantage of the IRA first-time homebuyer's provision, plan ahead. Any IRA funds distributed to you must be used within 120 days of your receiving them.
The money can’t be used to prepay an existing mortgage or on general furnishings. Instead, it has to be used to acquire the property. And the property is considered "acquired" on the date you sign the contract to purchase it, not the date escrow actually closes.
The Bottom Line
If you need to tap an IRA to fund your home purchase because you have no other options, reconsider the timing of your home purchase. It probably makes better financial sense to wait until you’ve saved the down payment while leaving your retirement savings intact.