First-time home-buyers are often surprised by the requirements of obtaining a mortgage, especially when it comes to the down payment. One way you can improve your chances of getting a home loan is by putting at least 20% down at the time of purchase. For existing homeowners like me, coming up with a 20% down payment usually starts with selling the home I’m in right now and using the equity to make a down payment on my next home.
But what about someone that may be buying a home for the first time? Coming up with a $50k down payment on a $250k home may take several years of aggressive saving, but your retirement account may not be a bad place to go for the additional funds needed to get you on the path to home ownership. In fact, the IRS offers certain breaks for taxpayers that choose to use retirement assets to purchase a first home. Here’s how it works.
Who qualifies as a first-time home buyer?
Interestingly enough, you don’t actually have to be buying a home for the first time in your life to be considered a “first-time” home buyer. IRS publication 590 defines a first-time home buyer as any home buyer that has had no present interest in a main home during the 2-year period ending on the date of acquisition of the new home. In other words, as long as you haven’t lived in a home you owned for the last two years, you are considered a first-time home buyer even if you owned a home previously. If you are married, your spouse must also meet this no-ownership requirement.
Using your IRA
Most people know that when you take money out of a traditional IRA prior to age 59½, there is usually a 10% penalty for early withdrawal. However, the IRS offers an exception that allows you to withdraw up to $10,000 over a lifetime without penalty for first-time home purchases. Keep in mind that while the distributions are not subject to penalty, they are still subject to income taxes. $10,000 probably won’t be enough to cover your full down payment, but it can help.
Does it make a difference if I use a Roth IRA?
It does. If you’ve owned a Roth IRA for at least five years, any distributions used for a first-time home purchase (subject to the $10,000 lifetime limit) are treated as qualified distributions. That means the amount distributed will not only be exempt from penalties, but also income taxes. If you have not owned a Roth IRA for at least five years, your distribution may still avoid penalties but some or all of it may be subject to income taxes.
How to use more than $10,000 from your Roth IRA
One thing you should understand is that any money you put into Roth IRAs comes out first and is not subject to taxes or penalties. After all, you already paid taxes on the money before it went in. Therefore, the first-time home purchase exception described above is really only applicable after you have withdrawn all of your contributions, so many people find themselves withdrawing all of their initial contributions PLUS $10,000 of growth with no tax consequences.
Using your 401(k) or 403(b)
The same exception doesn’t apply to your retirement account through work. The only way to withdraw money from your employer-sponsored retirement plan (e.g. 401(k)) for a home purchase while you are working and under age 59 1/2 is through a hardship withdrawal. Buying a home is one of the reasons allowed for a hardship withdrawal, but you will pay that early withdrawal penalty if you’re under age 59 1/2 and any pre-tax withdrawals or growth in your Roth 401(k) will be taxed as well.
Using a plan loan instead
Some people use the 401(k) loan provision to access those funds to buy a home without the tax. Many companies also give you longer than the standard 5 year pay-back period to repay a residential 401(k) loan, but you may have to prove that you actually closed on a home. Finally, the interest you pay goes back into your own account but will be double taxed when you withdraw it.
So is it a good idea to use retirement assets to purchase a home?
That depends. If you plan on using the equity in your home as supplemental income in retirement, some investors may consider this a good way of diversifying your retirement portfolio. However, if you have trouble making payments on the loan, not only could you end up losing your place to live, but you may also jeopardize part of your retirement nest egg. Read this other Forbes article for more things to consider and like with all financial decisions, you should weigh your options carefully before deciding which approach to take.