There are many prospective buyers that are gearing up to purchase their first house or a new one after years of renting. There may be times when the buyer doesn’t have enough cash to meet the down payment requirements. If this is the case, they may want to consider using some of their retirement savings. Can they do so without incurring a tax penalty?
Withdraw up to $10,000 from your IRA penalty-free
You can withdraw up to $10,000 from your IRA without incurring the 10% early withdrawal penalty if the funds are used for your first home. In addition, the internal revenue code even allows parents to pay for the down payment on behalf of their children with their own IRA funds without penalty (source: IRS publication 590, IRC Section 72(t)). That’s the good news. Now for the bad news. You will still owe taxes on the withdrawal since the IRA was funded with pre-tax dollars and has likely appreciated since the account was initially funded. If you are the owner of a Roth IRA, you wouldn’t owe any taxes from withdrawing on the principal since that account is funded with after-tax dollars. However, any earnings that you withdraw from a Roth IRA would be taxable.
Are there any exceptions to the $10,000 exception?
It sounds strange, but there actually are exceptions to the exception. First, you must be younger than 59½ years old to avoid the penalty. In addition, you cannot continue to buy new homes that meet the two year ownership test and withdraw $10,000 from your IRA. It’s a once in a lifetime tax benefit. Also, if you do decide to withdraw up to $10,000 from your IRA, you only have up to 120 days to utilize those funds to purchase your home. That may not seem like a big deal, but many homes take longer than expected to close.
Any other tax considerations?
It’s possible that by withdrawing from your IRA your adjusted gross income will increase to a higher tax bracket. That could have significant tax implications to other transactions you’re considering for the year.
What about 401(k)s?
Generally, the only way to use a 401(K) for a down payment without incurring a penalty is to borrow against the account. The pros are that it provides immediate access to cash, there’s no tax impact, and the taxpayer be paying off the loan at a low interest rate. The major drawback is that repayment is required immediately if you leave your job or are fired (i.e. within 60 days). In addition, failure to repay results in tax consequences and penalties on the outstanding balance.
We generally don’t recommend 401(k) loans, unless it’s a last resort option and there is significant job security. The only other option is a hardship withdrawal. However, there must be an immediate and heavy financial need in which the withdrawal is necessary to satisfy that need. Essentially, this means that the 401(k) loan must be exhausted as well as all other resources before a hardship withdrawal can be taken on the purchase of a home. It can never be at the convenience of the taxpayer.
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