Just because you can doesn’t mean you should.
It’s an early lesson that applies to many problems in life, including this one: Using your Roth IRA to buy a home is pretty easy, especially as a first-time home buyer. But should you? Maybe not.
Using a Roth IRA to Buy a Home
The Roth IRA rules for distributions make the account a tempting source of money. To understand them – which is the key to obeying – it helps to pretend that the money in your account is in two envelopes: the contributions you made and the return on those contributions.
To the contributions:
You can withdraw your contributions to your Roth IRA at any time without giving a reason. There are no taxes or penalties no matter how you spend the money or when you make the distribution.
For the investment income:
If it has been at least five years since you made your first Roth IRA contribution:
Withdraw up to $ 10,000 tax and penalty free on your first home. The IRS has an unusually loose definition of “first” here: You are considered a first-time buyer if you or your spouse has not had a primary residence in the past two years.
The five-year clock starts on January 1st of the year in which you made your first Roth IRA contribution.
If you are feeling generous, you can also use this money to buy a house for your child, grandchild or your parents for the first time.
If it has been less than five years since your first Roth IRA contribution:
You can deduct up to $ 10,000 in investment income on your first home, but you will pay income tax on the distribution. You do not pay any early repayment penalties.
You can also use the money on a child, grandchild, or parent who meets the definition of a first-time home buyer.
The $ 10,000 cap is a lifetime cap, which makes this a one-time deal for most people, and the funds must be used within 120 days of being distributed. But the flexible contribution rule means you may never have to dig into the stricter rules on investment income. The IRS says that money from a Roth IRA comes in a specific order: contributions first, followed by money converted from another account such as a traditional IRA or 401 (k), and finally, earnings.
Conclusion: If you have contributed at least as much as you would like to deduct to finance your home purchase, you can take over this distribution tax and penalty-free. If you haven’t, you can get the total of your contributions plus up to $ 10,000 tax and penalty free as long as your first Roth IRA contribution was at least five years ago and you qualify as a first time homebuyer.
Think carefully about using a Roth IRA to buy a home
A Roth IRA can be a relatively simple source of money for your home purchase, but that doesn’t make it the best source. Here are some things to keep in mind before converting your Roth IRA into a home down payment:
1. Current interest rates
Part of that decision depends on where your money will work harder: home-tied or publicly invested through your Roth IRA. To make this comparison, you want to compare your mortgage rate with your long-term return expectations.
“Think where your money will work harder: tied at home or invested through your Roth IRA.”
Mortgage rates aren’t as good as they used to be, but they’re still low enough that most long-term investors get better returns from keeping their money in the market. Most experts consider 6% a reasonable average annual return on investment; that’s a conservative estimate since historically the average annual stock market return is 10%. Your own return largely depends on how your money is invested.
When buying a home in a low interest rate environment, it can make sense to borrow more and keep less on deposit, especially since interest on mortgage debt of up to $ 750,000 is tax deductible.
2. Your deposit options
The ideal down payment is 20% of the home price as it gives you the best chance of getting approval, along with access to lower mortgage rates and lower upfront and ongoing fees.
But that’s a huge amount of money. If there is a need to loot your Roth IRA, it makes sense to consider alternatives, especially when interest rates are low. There are programs that can help you buy a home only 3% less.
3. Your goal for retirement savings
In particular, your progress towards the fulfillment. Sure, there are a few rare birds that can overfund their retirement accounts. But the rest of us are scraping together every penny to save nearly enough for retirement.
In that case, dipping into your Roth IRA could get you back on the starting line. Not only are you spending money you’ve earmarked for retirement, you’re also losing the tax-free growth that makes the Roth such a powerful retirement account
Use a Pension calculator to assess where you stand. You can run the numbers based on your current savings and then back on what you have left when you use your Roth to buy a home. How much would that set you back? Could you recover, and if so, how quickly? These are questions you want to answer before tapping this Roth.