An IRA is a tax-advantaged retirement savings account for individuals set up through a bank or other financial institution, life insurance company, mutual fund or stockbroker. Although people often mistakenly think of IRAs as investments, they are actually accounts in which investments are held. Many IRAs let you pick from a selection of individual securities for the account, such as stocks, bonds, mutual funds and exchange-traded funds (ETFs) – or you can choose a “single-fund” option, where the asset allocation is done for you.
Once you open an IRA, you can invest up to the maximum contribution limit each year (for 2018, that’s $5,500 if you’re under age 50, or $6,500 if you’re older). When you reach age 59½, you have the option to start withdrawing money from your IRA without penalties. Once you turn age 70½, you have to take the required minimum distributions (Roth IRAs are only subject to RMDs after the death of the owner).
But what happens if you want to use some of the money in your IRA to buy a house and you're not 59½? Even though there are very specific rules surrounding IRA investments and withdrawals, it’s possible to use funds from an IRA, penalty-free, to buy a house. Here are your options.
Because IRAs are intended to help you save for retirement, the Internal Revenue Service (IRS) doesn’t want you to withdraw any money before you turn 59½. If you do, you might have to pay a 10% early withdrawal penalty. The Taxpayer Relief Act of 1997 changed some of the IRA rules, and it's possible to withdraw money penalty-free in certain situations, including to buy, build or rebuild your first home. (To read about other situations in which money from an IRA can be withdrawn without penalty, see 9 Penalty-Free IRA Withdrawals.)
To use money in your IRA to buy a house, you must be a first-time homebuyer. You are considered a first-time homebuyer if you haven’t owned a home (or had financial interest in one) at any point during the last two years. So, even if you owned a house at some point in the past – say, five years ago – you may well meet the first-time buyer requirement.
The rules differ depending on which type of IRA you have. If you qualify as a first-time homebuyer, you can withdraw up to $10,000 from your traditional IRA to help cover the costs of buying a home. Your spouse can also withdraw up to $10,000 from his or her IRA (remember, IRAs are individual retirement accounts; you don’t “share” them with a spouse). Remember that even though you’ll avoid the 10% early withdrawal penalty, you’ll still owe income tax on any amount you (and your spouse) withdraw.
The rules are a bit different with a Roth IRA. You can withdraw contributions you’ve made to your Roth IRA tax-free and penalty-free at any time, for any reason (this is because you’ve already paid taxes on the contributions). Once you withdraw your contributions, you can take out up to $10,000 of your earnings for a first-time home purchase – without paying the 10% penalty. As an added bonus, if you’ve had the Roth IRA for at least five years, the withdrawn earnings are tax-free; if it’s less than five years old, the earnings are taxable.
“Some first-time homebuyers may want to have a substantial down payment to avoid private mortgage insurance. This is the perfect time to enlist the support of a CFP professional to help you to determine the most efficient way to access funds for the down payment,” says Marguerita M. Cheng, CFP®, CEO of Blue Ocean Global Wealth in Gaithersburg, Md.
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. All the securities and investments are held in an account administered by a specialized, self-directed custodian or trustee (rather than a mainstream bank or brokerage firm, as with standard IRAs).
One of the biggest attractions of SDIRAs is their flexibility: SDIRAs allow you to invest in a wider variety of investments than standard IRAs – everything from LLCs and franchises to precious metals and real estate. And “real estate” doesn’t refer merely to houses: You can also invest in vacant lots, parking lots, mobile homes, apartments, multifamily buildings and boat slips.
Still, don't expect to buy a house with your SDIRA and live in it: Real estate purchased with funds from an SDIRA must be an arm's-length transaction – and therefore can't benefit you or your family (including parents, grandparents, children, spouse, 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. Since the SDIRA – not you – owns the home, using personal funds or even your time (sweat equity) to benefit the property is also prohibited.
“There are many ways you can use your self-directed IRA to purchase real estate inside your IRA. 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 not for personal use, you can use your IRA to make that purchase,” says Kirk Chisholm, wealth manager at Innovative Advisory Group in Lexington, Mass.
Buying real estate with an SDIRA is complicated and it's easy to make a mistake. It's recommended that you work with a qualified tax accountant to ensure that all transactions are done according to current IRA rules.
Also, all the money you use to fund a SDIRA investment property has to come out of the SDIRA. If you owe taxes, say, or the property requires repairs – like a new roof – you have to use funds from the SDIRA, and not another account, to cover the expense. Similarly, any money the investment property earns has to go back into the SDIRA. If you buy a house and rent it out, for example, the rent money you collect has to go back into the SDIRA. (To learn more about opening a SDIRA, read Self-Directed IRA: The Right Move For You?)
Once you turn 59½, you can start withdrawing assets – including the house – from your SDIRA. Keep in mind that withdrawals from your SDIRA, including the full value of your home, are taxable income for that year (unless you have a self-directed Roth IRA). You can then live in the home since it will have become your personal property after distribution.
Tap Your 401(k) Instead
If you have a 401(k), 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. Also, the interest rate 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. Another minor point is you are paying the retirement loan back with after-tax dollars so the loan may be more expensive than you may think,” says Peter J. Creedon, CFP®, ChFC®, CLU®, CEO, Crystal Brook Advisors, New York, N.Y.
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; if you’re under 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 are older than 55 when you leave your job).
The Bottom Line
Because SDIRAs require that you take an active role in your retirement planning, they are not suitable for everyone. In addition, there are very specific rules and regulations regarding SDIRAs, so it’s important to do your homework ahead of time and consult with an experienced financial planner, attorney and/or tax accountant before making any decisions.
And one other thing about standard IRAs: Even though you can’t take a loan from a traditional or Roth IRA, you can access money from an IRA 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, income (including state) taxes and penalties are imposed. Currently, you're limited to only one “tax-free rollover” a year, regardless of the number of IRAs you own. Investopedia has curated a list of the best brokers for IRAs for those looking into these account types.