It’s not an easy time to be a home buyer, since bank requirements for mortgages are stringent and in some markets, the inventory is low. One way to boost your chances of getting a mortgage and winning a bidding war: a bigger than usual down payment.
Tapping your retirement account for a larger down payment on a home purchase has certain advantages, according to a recent article in Forbes, “Should You Use Your Retirement Savings to Buy a Home? Among the advantages are some tax breaks from the IRS, if you qualify as a first-time home buyer.
Get this: you don’t actually have to be buying a home for the first time in your life to be considered a “first-time” home buyer. The IRS defines a first-time home buyer as any home buyer who has had no present interest in a main home during the two-year period ending on the date of acquisition of the new home. Therefore, provided that you haven’t lived in a home you owned for the last two years, you are considered a first-time home buyer, even if you previously owned a home. If you’re married, your spouse also has to satisfy this requirement.
If you withdraw money from a traditional IRA before age 59½, there's typically a 10% penalty for early withdrawal. However, the IRS has an exception that lets you to withdraw up to $10,000 over a lifetime, without a penalty for first-time home purchases. You should also note that while the distributions are not subject to penalty, they are still subject to income taxes. If you’ve owned a Roth IRA for at least five years, any distributions used for a first-time home purchase (subject to the $10,000 lifetime limit) are treated as qualified distributions. This means the amount distributed will be exempt from penalties and income taxes. If you haven’t owned a Roth IRA for at least five years, your distribution may still avoid penalties but some or all of it may be taxed.
Any money you put into Roth IRAs comes out first. It isn’t subject to taxes or penalties, because you’ve already paid taxes on the money before you deposited it. Therefore, the first-time home purchase exception is really only applicable, after you’ve withdrawn all of your contributions. As a result, many people withdraw all of their initial contributions plus $10,000 of growth with no tax consequences.
This same exception does not apply to your retirement account through work. The only way to withdraw money from your employer-sponsored retirement plan (e.g., your 401(k)) for a home purchase, while you are working and under age 59½, is through a hardship withdrawal. Buying a home is one of the reasons allowed for a hardship withdrawal, but you’ll have the early withdrawal penalty if you’re under age 59½, and any pre-tax withdrawals or growth in your Roth 401(k) will also be taxed.
Another option is to use the 401(k) loan provision to access those funds to buy a home without the tax. Many companies also let you have longer than the standard five-year pay-back period to repay a residential 401(k) loan. However, you may have to show that you actually closed on a home. The interest you pay goes back into your own account, but will be double taxed when you withdraw it.
This could be a risky move, especially if you are going to use the equity in your home as an income stream during retirement. If you can’t make payments on the loan, you could lose both your home and your retirement money. Speak with your estate planning attorney to work through the details, before taking this step. You don’t want to jeopardize your retirement or your home ownership. There may be better alternatives.
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