Updated June 14, 2017
First-time home-buyers are often surprised by the requirements of obtaining a mortgage, especially when it comes to your 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.
Who qualifies as a first-time homebuyer?
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” homebuyer. IRS publication 590 defines a first-time homebuyer as any homebuyer 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 homebuyer even if you owned a home previously. If you are married, your spouse must also meet this no-ownership requirement.
What are the tax benefits of using a traditional IRA for a first-time home purchase?
Well, as you probably know, when you take money out of a traditional IRA prior to age 59½ there is usually a 10% penalty tax for early withdrawal. However, the IRS offers an exception for first-time homebuyers: first-time homebuyers may 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.
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.
One thing you should understand is that Roth IRA distributions are subject to ordering rules, which basically means any money you put in comes out first and is therefore not subject to taxes or penalties (since you already paid taxes on the money before it went in). Therefore, the exception described above is really only applicable after you have withdrawn all of your contributions.
Do I get the same benefits with an employer-sponsored retirement plan?
Not really. The only way to tap money in an employer-sponsored retirement plan (e.g. 401(k)) for a home purchase while you are working is through a plan loan or hardship. Plan loans are not subject to taxes and penalties—as long as you don’t default—but generally have to be paid back within five years (although some plans allow more years for funds used to buy a home). Also, if you leave work before paying off the loan, many plans require you to pay off the balance within a few months of separation or risk defaulting on the outstanding balance.
If you intend to use your employer-sponsored retirement plan assets to help pay for a home purchase, you may want to roll them over to an IRA after separation as the distribution rules for IRAs are generally more favorable than those of employer-sponsored retirement plans.
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 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.