Coming up with a down payment and money to cover closing costs can be difficult. If you are unable to save the money with your traditional earnings, but you have a Roth IRA account, you do have some options. Whether you must pay a penalty depends on your exact circumstances. What the IRS cares about the most is whether you are a first-time homebuyer or a subsequent homeowner – this is where the largest line of determination exists.
First-Time Homebuyers
First-time homebuyers have the greatest advantages if they want to use their Roth IRA money for a down payment or closing costs. The definition of a first-time homebuyer might differ from what you think – generally, people who never owned a house before qualify. A unique aspect is the buyers that owned a home in the past, but not within the last 2 years. A common example is people who lost their house in a foreclosure a few years ago and are now ready to get back on track. Since they lost the home they rented a place to live, so they do not have a principal residence they could call their “own” during the last two years which qualifies them as first-time homebuyers.
The Roth IRA Requirements for First-Time Homebuyers
If you fall under the “first-time” homebuyer category, you have several requirements you must meet. The most important is the need to own your IRA account for at least 5 years. If you owned it for less than 5 years, you can still withdraw the money, but not without penalty. For now, we will cover the borrowers who held their account for 5 years. Beyond owning the account for a specific period, you must not withdraw more than $10,000 and you must use this money to pay the down payment, closing costs or both.
To complicate matters, you can only use the money in one transaction. This means if you only withdrew $6,000 this time, you cannot use the additional $4,000 for a subsequent home purchase. The penalty waiver only occurs one time; it is not a lifetime benefit. If you follow these rules, the IRS considers it a qualified distribution and you do not need to pay any taxes or penalties for early withdrawal.
You have to be careful to avoid the early withdrawal period, though. If you owned your account for less than 5 years, you should not withdraw any interest or dividends you earned. If you do, you will have to pay taxes on the earnings. Being a first-time homebuyer, though, entitles you to the first-time homebuyer penalty waiver, which saves you the 10% penalty on the amount you withdraw.
Withdrawals for Non-First-Time Homebuyers
If you already owned a home within the last 2 years, you are not a first-time homebuyer, but you can withdraw your money. The rules from above do not apply to you, though. You cannot withdraw $10,000 even if you held your account for at least 5 years. The amount you can withdraw depends on the amount you contributed of your own money. This means the income you directly placed in the Roth IRA, not the earnings. Any money you earned in interest or dividends is not “your income” and you cannot withdraw it without penalty.
The money you are able to withdraw is the contributions you made over time. Any of your “earned” income which you already paid taxes on and placed in the account is yours to do with what you wish. If you need the money to purchase a home, you are free to withdraw it. The earnings above and beyond your contributions must remain in the account, though. If you choose to withdraw your earnings, you will pay a 10% penalty along with the taxes on your earnings, which could eat away at the money you have available for your down payment or closing costs.
Don’t Withdraw Too Early
Even though there are ways around using your Roth IRA without penalty or even tax liabilities, you have to be careful. If withdraw the money from your account more than 120 days before the qualifying event (buying a home), you could face penalties.
Should You Use Your Roth IRA to Purchase a Home?
The larger question is whether you should use your Roth IRA to purchase a home. Does it make financial sense? Most financial experts say it does not make sense, especially since money is so “cheap” right now. Instead, you can obtain the money you need in other ways.
Take a Larger Mortgage
Everyone tries to minimize how much they borrow, but it is not always necessary. When money is “cheap” as it is right now, you make more money with a larger mortgage and leaving your money in the retirement account. This might mean purchasing a slightly less expensive home or even a smaller home. Consider the long-term effects of your decision and really consider whether you need a larger or more expensive home.
Consider Other Mortgage Options
Using a different loan program may also help you. Even if you envisioned only applying for conventional financing, you should check out all of your options. Consider government-backed loans, such as the FHA program or even browse through your subprime options as they may provide you with the loan you need without touching your IRA.
The bottom line is that using your Roth IRA is a personal decision. How much money did you invest? How long has the money sat in your account? Do you know the consequences of withdrawing $10,000 from your account? Do not look at the consequences now, but in the future. If you are in your 20s, consider what the $10,000 would look like in 30 years after it has time to grow. Do you really want to take it out now and start all over again? Looking at the long-term effects can help you decide the right way to make your down payment or if you need to shop for a less expensive/smaller home to make the right financial decision.
