Using Your IRA To Purchase A Home: Can And Should You Do It?
Individual retirement accounts, or IRAs, provide individuals with a tax-advantaged way to save for retirement without having to create a plan through an employer.
The tax-advantaged status of your IRA investments means there are certain rules for how and when you can tap into those funds. If you’re considering withdrawing from your traditional or Roth IRA to fund a down payment on a house, it’s important to understand these rules as well as the potential drawbacks of using your retirement savings for something other than retirement.
Let’s take a look at the ins and outs of the process of withdrawing from the two types of IRAs for a home purchase and how that could affect your retirement plans.
Withdrawing From A Traditional IRA: How It Works, Penalty Exemptions And Drawbacks
Traditional IRAs are funded with pretax or tax deductible dollars, meaning that you don’t pay taxes on the income that you put into your IRA. When you retire and begin taking money out of the account, you’ll pay regular income tax on your withdrawals (also called distributions).
Basically, with a traditional IRA, you won’t pay taxes right now; you’ll pay them later.
Who Is Eligible For A Penalty-Free IRA Withdrawal?
To get the most out of your retirement savings, you won’t want to withdraw from your IRA before reaching retirement age.
If you take money out of your traditional IRA before you reach the age of 59 ½, not only will that money be counted as taxable income, but you’ll also typically be subject to an additional 10% penalty tax if you aren’t taking that money out for one of the situations the IRS allows exceptions for.
First-time home buyers are allowed an exception to this rule. The IRS defines a first-time home buyer as someone who hasn’t owned a home in the last 2 years. If you’re married, your spouse has to meet this requirement as well.
Withdrawals can also be made without having to pay the 10% penalty following the death or disability of the IRA owner, to pay for college tuition and other higher education-related costs, to cover medical expenses or to pay your health insurance premiums if you’re unemployed.
If you are age 59 ½ or older, you can withdraw penalty-free at any time. Once you reach age 72 (the law was recently changed from age 70 ½), you’ll have to take a required minimum distribution each year.
How Much Can I Withdraw?
If you’re a qualified first-time home buyer, you’ll be allowed to withdraw up to $10,000 from your IRA penalty-free.
This is a lifetime limit. For example, if you used $6,000 to fund a home purchase several years ago and you qualify for the first-time home buyer exemption again, you’ll only be able to withdraw $4,000 if you want to avoid the 10% penalty.
If you’re 59 ½ or older, you aren’t restricted on how much you can take out – keep in mind, however, that these distributions are considered taxable income.
What Are The Drawbacks?
As more people live into their 90s and beyond, many of us can’t afford to be shortsighted about retirement. When you withdraw from your retirement savings, you’re borrowing from your future financial security.
While a home purchase can also be an important part of building financial security and long-term wealth, it’s important to carefully consider the risk you’re taking and the potential growth you’ll be missing out on when you withdraw from your IRA.
Thanks to the power of compound interest, your money earns you more money when you keep it parked in a retirement account. When you take funds out of that account, you’re cutting into the amount you could end up with when it’s time to retire – potentially losing out on a significant amount of money.
Additionally, if you don’t qualify for the first-time home buyer exemption, you’ll have to pay the hefty 10% penalty on your withdrawal in addition to regular income tax.
However, that’s not to say that using your IRA to fund a down payment on a house is always a terrible idea that nobody should ever even consider. If you’re still a long way out from retirement and have time to make up for the money you take out or you have other retirement savings and feel comfortable with how much you have saved, you might find that this option makes sense for you.
If this is something you’re considering, it’s always a good idea to talk with a financial advisor who can evaluate your individual situation and help guide you to a solution that works best for you.
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Withdrawing From A Roth IRA: How It Works, Tax And Penalty Exemptions And Drawbacks
Roth IRAs are funded using after-tax dollars. Because you’ve already paid taxes on the money, you won’t pay taxes when you withdraw it in retirement or when you take another type of qualified distribution.
With a Roth IRA, you pay taxes now, rather than later.
How Much Can I Withdraw From My Roth IRA Without A Penalty?
One of the benefits of a Roth IRA is that, because you already paid taxes on that money, you can withdraw your contributions at any time, incurring no taxes or penalties.
The key word here is contributions, or the money that you initially put into the account. Because money in an IRA is invested in stocks, bonds, funds and other types of securities, the money will grow over time. That’s your earnings.
So, say you have $25,000 in a Roth IRA. Of that, you’ve contributed $15,000 of your own money, and the rest has come from the growth of your investments. You can typically access that initial $15,000 at any time, no strings attached. If you want to take out more than that, it may be subject to penalties or taxes if you don’t qualify for an exception to these rules.
If you’re under the age of 59 ½, there are limits to when you can access your Roth IRA’s earnings.
If you’ve had the account for less than 5 years, you can withdraw earnings penalty-free for certain qualified reasons, including to fund a first-time home purchase (up to a $10,000 lifetime limit). You will, however, be taxed on this withdrawal.
If you’ve had the account for more than 5 years, you won’t be subject to taxes or penalties when withdrawing earnings for a first-time home purchase (up to $10,000) or if you qualify for a different exception, such as using the money to pay for certain medical expenses.
If you’re age 59 ½ or older and have had your Roth IRA for less than 5 years, you won’t incur a penalty but you will have to pay taxes on your earnings. Once you’ve had the account for 5 years, you can begin withdrawing money without any taxes or restrictions.
What Are The Drawbacks?
As with a traditional IRA, withdrawing money from your Roth IRA before reaching retirement can potentially jeopardize your future financial security and force you to pay penalties and taxes you otherwise wouldn’t have to pay.
Having a tax-free source of income in retirement can be incredibly beneficial. If you’re considering taking money from your Roth IRA to fund a home purchase, consider how much you might need that money later on.
I’m Still Interested. How Do I Report An IRA Withdrawal?
When you make a withdrawal from your IRA, you’ll likely receive a 1099-R form from the financial institution that manages your account. You’ll use this form to complete that year’s taxes.
Keep in mind that when you take a qualified distribution from your IRA to purchase a home, you must use those funds within 120 days to avoid taxes or penalties.
For more information, speak with a tax professional who can give you personalized advice.
Everyone’s financial situation is different. The question you need to answer is: Where does it make the most sense to keep your money – building equity in a house, or growing your nest egg?
Financial experts tend to advise against using your retirement funds for a home purchase. Why is that?
Think of it this way: you can get a loan for all sorts of things, and there are many first-time home buyer programs and low down payment options on many types of mortgages – 3% down for conventional loans, 3.5% for FHA loans and even 0% down on USDA or VA loans.
There aren’t, however, loans for retirement. While there are situations where it can make sense to use money from an IRA to help fund a down payment on a home, be sure you’re considering your entire, long-term financial picture before making any decisions.
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