This is an update of one of our most-requested articles, previously published in July 2022.

If you are considering buying your first home, coming up with a down payment can be daunting. You may, however, be able to tap your IRA if you qualify as a first-time home buyer.

Although it’s wise to earmark IRA funds for your retirement, there is an exception to the 10% early distribution penalty tax, which is available for a qualified home buyer to withdraw funds of up to $10,000 (lifetime limit) to help offset the cost of purchasing a home.

Usually, if you are under age 59½ and take a distribution from your IRA, you are subject to income tax (federal plus state, if applicable) plus an additional 10% early distribution penalty tax. Such penalty is waived if you qualify for the first-time home buyer exception.

Importantly, the first-time home buyer exception applies only to IRAs (including SEP and SIMPLE). The first-time home buyer exception, however, does not apply to distributions from a qualified retirement plan (i.e., 401k, 403(b), etc.).

Who qualifies as a first-time home buyer?

A qualified first-time home buyer is an individual who has not owned (and, if married, whose spouse has not owned) a principal residence during the two-year period ending on the date of acquisition of the principal residence. This means that if a married couple is buying a jointly owned home, and either partner owned a primary home in his or her individual name in the prior two years, the exception does not apply.

Even if you previously owned a home, you could qualify if you haven’t owned a home or had an ownership interest in a principal residence in the past two years. (The two-year period ends on the date of acquisition of the home you are looking to purchase.) For example, say you once owned a home but decided to sell it 10 years ago and to rent instead—you would qualify as a first-time home buyer.

IRA funds can also be used to assist certain family members in purchasing a home, assuming they qualify as a first-time buyer, including an IRA owner’s spouse, child, grandchild, or ancestor of such individual or the individual’s spouse.

Using a Roth IRA for a first-time home purchase

A Roth IRA can provide more than the $10,000 limit, if needed, without being subject to taxable income. Since the $10,000 exception applies to funds that would otherwise be subject to the 10% early-distribution penalty tax, a qualified first-time home buyer could withdraw up to $10,000 in earnings plus contributions. Why? Contributions to a Roth IRA are distributed tax and penalty free at any time, any age, and without regard to the five-year rule.  

For example, let’s assume an individual has a Roth IRA valued at $50,000 composed of $40,000 in contributions and $10,000 in earnings. The first-time home purchase withdrawal could be up to $50,000 without being subject to taxable income and/or the 10% early distribution penalty.

Importantly, the five-year rule (for withdrawing up to $10,000 of earnings) would need to be satisfied.

The distribution rules that apply to a first-time home purchase for a Roth IRA do not apply to Roth 401(k) contributions.

How to use an IRA to buy a home

$10,000 lifetime limit: The rules allow for a penalty-free distribution of up to $10,000 to buy, build, or rebuild a principal residence. $10,000 is a lifetime limit. Notably, if you and your spouse each qualify as a first-time home buyer, and you each have your own IRA, you can each take up to $10,000, for a total of $20,000, for the same purchase.

Use for qualified acquisition costs: Under Internal Revenue Code Section 72(t)(8)(C), you can use the funds for qualified acquisition costs, such as closing costs and financing fees.

Use the funds within 120 days: You must use the funds to acquire a home within 120 days from the day they are received.

Notably, if the home purchase is delayed or cancelled, you can contribute the funds back into your IRA. You have 120 days from the date of the distribution to do this, versus the usual 60-day window for completing an IRA rollover. Such a contribution is treated as a rollover to your IRA.

Also, if the purchase is cancelled or delayed, the one-IRA-rollover-per-year rule does not apply.

Keep good records to claim the exception: Your IRA custodian will likely report the distribution as an early distribution to both you and the IRS. You therefore need to claim the exception to the 10% early-distribution penalty when you file your tax return for the year coinciding with the IRA distribution.

Although you will not pay the penalty, your distribution will be subject to income tax (unless basis is included in the distribution). And, more importantly, any funds you withdraw from your IRA early won’t have the opportunity to compound over time. So, consider how much you have saved for retirement and factor that into your thinking.

Remember to keep complete records in the event the IRS flags your return.

If you are contemplating using your IRA to fund a first-time home purchase, be sure you understand both the financial and tax implications and consult with your financial and tax professional.

Questions? Please contact your Lord Abbett representative at 888-522-2388.