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Is Tapping Your IRA for a Home Down Payment a Good Idea

April 03, 2015

Although tarnished by the sluggish economy over a number of years, the “American Dream” of owning a home is still a top priority for many people. And, with the current low home mortgage interest rates, the appeal of home ownership is increased. However, it takes cash to close a home ownership deal, leading many people to search for ways to increase the money they have available for closing.

Many potential homebuyers may have a cash solution to home ownership they haven’t considered: their Individual Retirement Account (IRA). But, is it a good idea and right for you?

Withdrawal Exceptions
Generally, a 10 percent “early withdrawal” penalty tax applies to distributions from an IRA before you turn age 59-1/2.  However, a special rule designed to encourage home ownership provides an exception to this penalty for IRA distributions up to $10,000 used by “first-time” homebuyers to pay costs related to buying a home. Of course, the regular income tax still applies to the distribution unless it is from a Roth IRA. However, if you have held the Roth IRA for less than five years, the earnings portion of a distribution will be subject to the regular income tax in the same manner as other IRAs.

Some key points about utilizing this exception to the early withdrawal penalty include:

  • You do not really need to be a “first-time” homebuyer; the taxpayer and spouse, if any, simply must not have owned a home in the past two years.  The statute defines “first-time homebuyer” as someone (including, if married, his or her spouse) who has not owned a principal residence for two years. Thus, even if you or your spouse have previously owned a home, you may qualify for the penalty exception.
  • Others in your family can be the homebuyer. The first-time homebuyer can be the owner of the IRA, his or her spouse, or any of their children, grandchildren or ancestors. 
  • The $10,000 maximum amount is a lifetime limit.  The $10,000 limit is actually a cumulative lifetime limit for each IRA owner. While not explicitly stated in the statute, both spouses filing a joint return should be able to withdraw up to $10,000 from their respective IRAs during their lifetimes under the first-time homebuyer exception. Thus, for example, a husband and wife can each withdraw $10,000 from their respective IRAs to fund $20,000 of a child’s down payment for a home.
  • You have 120 days to use the funds withdrawn from the IRA. The amount withdrawn for a first-time homebuyer must be used to pay for “qualified acquisition costs” within 120 days of the distribution. Qualified acquisition costs include the costs of acquiring, constructing or reconstructing a residence as well as usual or reasonable settlement, financing or other closing costs. In light of the 120-day requirement, you should wait to take a distribution intended to qualify for the first-time homebuyer exception until all material contingencies related to a home purchase or construction project are satisfied. In the rare instance where an unexpected problem delays closing of a home purchase or start of a construction project past the 120-day limit, a special provision permits a tax-free rollover of all or a portion of the distribution to the same or another IRA (as long as the rollover is completed within the 120-day post-distribution period).  The one-year waiting period between IRA rollovers does not apply in this case.
  • Only IRAs qualify for the exception. The first-time homebuyer exception only applies to IRAs.  Accordingly, it is not available for other types of retirement accounts like profit sharing plans and 401(k) plans. (Note, these other types of plans often provide for participant loans, subject to special rules and limitations, to help finance personal residences.)


Plan Ahead

Any early distribution from a retirement account deserves serious consideration. Taking funds out of an IRA reduces the amount growing “tax-free” and the amount of money ultimately available for retirement. Other alternatives, such as using cash in personal savings or increasing the amount of mortgage debt, may make more sense. Another exception to the early withdrawal penalty applies for “substantially equal periodic payments” that are spread over your life expectancy. Using this approach could allow you to take funds out of your IRA over time to offset a higher home mortgage payment, even if not for a first home.

Tax Concerns
Keep in mind the IRA distributions, when not subject to the early withdrawal penalty, are generally included in taxable income. The distributions could push you into a higher tax bracket and trigger a reduction of your itemized deductions and personal exemptions. Consequently, income tax projections are critical when evaluating the consequences of using the first-time homebuyer exception. And, while the IRA first-time homebuyer limitation amount should be covered by the annual gift tax exclusion amount, gift tax issues may also deserve attention when a family member other than a spouse uses your IRA distribution proceeds for a down payment on his or her home.

In spite of the potential downsides, the first-time homebuyer exception is an option that may make the difference in the ability to afford a new home or to avoid the need for private mortgage insurance. Be sure to keep contemporaneous records showing the funds withdrawn from your IRA are used for costs related to the new home.  

Should you have any questions about the first-time homebuyer exception for early withdrawals from an IRA, please contact your Eide Bailly LLP tax professional.