Right Way to Use an IRA for a Down Payment on a Home

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By Abby Hayes

If you're ready to buy your first home but don't quite have a down payment saved up, you may be able to tap into your traditional IRA for down payment funds. Right now is a great time to buy a house, which means it may just be worth it to pull some of your retirement money in to buy a home sooner rather than later.

Typically, you can't withdraw money from a traditional IRA before you turn 59½ without paying a hefty 10 percent penalty. But the 1997 Taxpayer Relief Act changed some of the IRA rules to allow IRA owners to withdraw money early, penalty-free, in certain circumstances. One of those circumstances includes buying, building or rebuilding your first home. So if you want to buy a house, and you qualify as a first-time homeowner and have money in an IRA, you may just have your down payment waiting for you already.

Who counts as a first-time homebuyer? As with all things IRS-related, the rules surrounding this IRA early withdrawal exception get a little complicated. You can actually qualify as a first-time homebuyer even if you've owned a home before.

The IRS rule says that as long as you haven't had financial interest in a home in the past two years before the date you're closing on your new home, you're technically a first-time home buyer. So if you sold your last home on Oct. 1, 2011, and haven't owned a home since then, you could use the funds in your IRA to put a down payment on a home that you sign a contract for any time after Oct. 1, 2013.
Note that to the IRS, the "date of acquisition" for your new home isn't the closing date. It's the date that you sign a binding contract to buy the home, or the date that the building or rebuilding of the home begins.

Also note that you can take money out of your IRA account for homebuyers other than yourself. IRA distributions can be used to cover home buying/building expenses for your spouse, child or grandchild, or your spouse's child or grandchild.

What can you use the money for? Under this exception, IRA owners can withdraw up to $10,000 total over a lifetime for "qualified acquisition costs" on a home. These costs include the cost of buying, building or rebuilding a home, as well as most settlement, financing and closing costs.
So whether you're buying a home as-is or building/rebuilding a new home, you can use up to $10,000 of your IRA money without paying that pesky 10 percent penalty.

You may still owe something. Even though this exception allows you to skip out on the 10 percent penalty for your IRA withdrawals, you'll still have to pay income taxes on the money you take as a distribution from your traditional IRA. Remember, money you've contributed to a traditional IRA hasn't been hit with income taxes yet, and you always have to pay those taxes eventually when you take a distribution. Depending on your financial situation, a $10,000 withdrawal could have some serious tax implications. It's probably a good idea to talk to a tax professional before making this withdrawal, just to be sure you can handle any taxes you need to pay on the distribution.

If you have a Roth IRA. Because the money that's in a Roth IRA has already been taxed, the rules and penalties surrounding these accounts are less strict. What you need to know, generally, is that Roth IRA withdrawals always take out funds in a particular order: first contributions, then conversion money, then earnings.

Since contributions and earnings have already been taxed, you won't pay income taxes on those. However, if you have to tap into your earnings to complete the whole distribution, you'll have to pay income taxes on the portion of your withdrawal that is made up of earnings. In other words, if your distribution is made up of $6,000 of money you contributed to the account, $1,000 of money you converted into the account and $3,000 of earnings, you'll only pay income taxes on that last $3,000, at your marginal tax rate.

Timing is essential. You have 120 days to apply your IRA distribution to your qualified homebuying expenses before it becomes a non-qualified distribution. This means if you take the withdrawal and your home purchase falls through, you could get stuck paying that 10 percent penalty on your withdrawal, which is now non-qualified. To avoid this, wait until the last possible moment before withdrawing your IRA funds. That way, you won't unexpectedly get stuck with an IRA withdrawal and no home to spend it on.

Some caveats. As with all retirement-related decisions, this one can have long-term ramifications. When you withdraw money from your IRA now, you no longer benefit from that lump sum's compounding interest for the next 10, 20 or 30 years until retirement. Also, the money you take from your IRA will, as has been noted above, be counted as taxable income. Depending on your other income, this could bump you into a higher tax bracket, resulting in a much bigger tax bill. So before you decide to withdraw from your IRA for your down payment, you may want to talk to a financial advisor about the potential ramifications of this decision.

More from U.S. News:
6 Tips for Boomers Leaving Big Homes Behind
3 Keys to Mastering New Home Hurdles
Get Your IRA in Shape by Tax Time

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