What is an IRA?
IRA stands for Individual Retirement Account. An IRA is an alternative saving option for retirement apart from employment-based retirement options. Examples of IRAs include Roth IRAs, traditional IRAs, and SIMPLE IRAs (Savings Incentive Match Plan for Employees IRAs).
Withdrawing money from your IRA before you are 59 and a half years old will warrant a 10% interest fee, plus additional income tax if this is a traditional IRA (Roth IRAs charge no extra tax). The reason for this is because IRAs are created as long-term retirement options. However, there are exceptions to this rule. Individuals looking to buy or build their first home qualify for a tax exemption when they withdraw from their IRAs.
Who is a First-Time Homebuyer?
The US Department of Housing defines what a first-time homebuyer is to avoid confusion when considering loan or financing options. First-time homebuyers can access numerous benefits from the Federal Housing Administration. A first-time homebuyer is an individual who has not owned a principal residence for the past two years.
Here are other instances of individuals who may fall under this bracket:
- A single parent who only co-owned a house with their former spouse.
- An owner of a house that is non-compliant with state or building rules.
- Owners of mobile homes or any house not built on a permanent foundation.
- In a couple, if one or none of the spouses has ever owned a home, they are placed in this category.
- A displaced homemaker who has only co-owned a home with their spouse.
IRAs for Purchasing Your First Home: Is it a Viable Option?
First, withdrawing money from your IRA to buy or build a new house means you should direct the money you received to the said purpose within 120 days of receiving the funds. If the deal goes sour or you change your mind, you are free to return the money to your IRA account and pay no tax, so long as you do within the same 120-day window.
Using the criteria specified above for first-time homebuyers, using your IRA to finance your first down payment has the following benefits:
- Withdrawals of up to $10,000 from your traditional IRA.
- A tax and penalty exemption from your Roth IRA withdrawals.
There are two ways that individuals may use to purchase their first home using their IRAs. One of these ways is using IRAs to qualify for a mortgage, and the other is by withdrawing the money (up to the $10,000 limit) and then using the cash to purchase the home. In the majority of this article, we focus on the latter.
A benefit of using IRA withdrawals for this purpose is that you can purchase houses for family members, such as you or your spouse’s child, grandchild, or parent. The only requirement is that these individuals must be first-time homebuyers, even if they are not.
Couples who are also thinking of purchasing their first home can take advantage of their first-time home-buying advantage. Each individual can withdraw $10,000 from their IRA and combine it to become $20,000. Similarly, a parent can withdraw $10,000 and combine it with their child’s withdrawal to make it a bigger sum as long as they are all first-time homebuyers.
The money from IRAs cannot be used to pay existing mortgages or for any other purpose than obtaining the house. Also, the $10,000 maximum withdrawal is the lifetime limit for first-time home purchases, meaning a withdrawal of more than $10,000 incurs a tax penalty. This tax is calculated according to one’s tax bracket.
With Roth IRAs, if your account is at least five years old, you can withdraw up to your total contributions. Unlike traditional IRAs, Roth IRAs also have the benefit of providing this money completely tax-free, yet it could be well above the former’s $10,000 withdrawal limit.
Alternative: IRA Rollovers
Preferably, IRAs are for retirement purposes, not investment or acquiring assets before retirement. So using withdrawals from your IRAs is not only risky but also a poor choice of judgment. What if you borrowed money from your IRA instead of withdrawing it? This is the best viable option for first-time homebuyers relying on their IRAs for financing.
IRA rollovers are tax-free periods that have a 60-day window within which individuals can take out some money and pay it back within the window period. This may not solve every financial requirement in purchasing or building a home, but it will go a long way in settling the down payment. Using this approach may be, and is often, cheaper than securing loans from banks or mortgages.
Paying back money into your IRA within 120 days also counts as a rollover. It is considered a contribution to your retirement savings account.
However, since withdrawals from your Roth IRA may not be ultimately praiseworthy, they are preferable to using 401(k) plans, for instance. However, 401(k) loans have no penalties or taxes and will only charge the interest on the loan.
Other alternatives to IRAs for first-time homebuyers include:
- Withdrawing from short-term savings accounts.
- Affordable mortgage and home financing options.
- Extending your time of saving and saving in a high yields savings account.
- Choosing a more affordable house, such as one with a cheaper down payment.
Frequently Asked Questions (FAQs)
Can I use my IRA to buy my first home?
Yes, you can, but the more important question is whether you should consider this option. As a cautionary tip, consider all available options and select the most affordable option in the long run.
Can I use my IRA to purchase a second home without penalties?
Generally speaking, no. IRAs only provide tax exemption to first-time homebuyers.
Why do I have to pay income tax for my traditional IRA withdrawals?
The contributions you make to your traditional IRA are tax deductible. For withdrawals, you will pay tax the same way you would on your income. On the other hand, Roth IRAs do not charge any tax or penalties on your withdrawals as long as your account was opened five years ago.
