It’s often difficult for young and middle-age taxpayers to come up with a down payment on a house. However, if you or your kids have your hearts set on a “dream home,” think outside the box.
Strategy: Consider an IRA as a secondary source of funds. Although IRAs are intended for retirement savings, tapping into your account might make sense if it helps to close the deal.
The main advantage of using an IRA is that the distribution may be exempt from the usual tax penalty for early withdrawals.
Here’s the whole story: Normally, if you receive a distribution from an IRA prior to age 59½, you must pay a 10% tax penalty, in addition to the regular income tax you owe. The 10% penalty is assessed on the taxable portion of the distribution (i.e., the pro rata amount representing deductible contributions and earnings).
However, there are several key exceptions to this rule, including one for the first $10,000 of funds received by first-time homebuyers. The definition of a “first-time homebuyer” for this purpose is quite broad: It includes an individual who hasn’t owned a home as his or her principal residence for the past two years.
Also, note that the IRA participant doesn’t necessarily have to be the homebuyer. For instance, if the situation dictates, you can use IRA funds to help purchase a home for your children, your grandchildren or your parents. But the distribution is still taxable in your top income tax bracket.
Qualifying for homebuyers exception
To qualify for the homebuyers exception, you must meet the following three requirements:
1. The distribution must be used to pay qualified acquisition costs within 120 days after the day you received it.
2. The distribution must be used to pay qualified expenses for the principal residence of the first-time homebuyer. Qualified expenses include acquisition costs (e.g., down payment), the cost of building or rebuilding the home and any usual or reasonable settlement, financing or closing costs.
3. You can’t have withdrawn $10,000 previously for a first-time home purchase (the $10,000 limit for this exception is a lifetime cap).
If both you and your spouse are first-time homebuyers, each of you may receive lifetime IRA distributions of up to $10,000 without paying the 10% penalty tax, as long as the distributions come from separate IRAs.
Can you take distributions from a Roth IRA instead of a traditional IRA? Yes, but be aware that the rules for Roths are slightly different than the rules for traditional IRAs.
For starters, you can take qualified distributions from a Roth in existence at least five years completely free of income tax and the penalty tax for early withdrawals. This includes distributions made after age 59½, those made on account of death or disability and qualified first-time homebuyer expenses (up to the lifetime limit of $10,000). And, to the extent that the distribution from a Roth is taxable, it is governed by special “ordering rules.”
Under the ordering rules, distributions are treated as coming first from contributions, which are not subject to regular income tax or penalties. Next are conversion funds, which are also exempt if they have been in the Roth for five years. Finally, distributions are treated as coming last from taxable earnings.
Therefore, the only funds distributed from a Roth IRA that would present a problem would be either earnings or conversion money that has been in the Roth for less than five years.
This provides Roth distributions with an advantage over distributions from traditional IRAs. But remember that the money you withdraw from a Roth will erode the tax-free nest egg you’ve worked hard to build up.
Tip: For more information about the IRA distribution rules, see IRS Pub. 590, Individual Retirement Arrangements.
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