A first home purchase is a big financial commitment. Not only are you taking on a mortgage, but you often need to deplete cash reserves to come up with the down payment. But what if you don’t have enough socked away for a down payment? or what if you prefer not to use all your cash reserves, leaving some cushion in your savings account? Normally the Internal Revenue Service levies a 10% penalty on distributions from a Traditional Individual Retirement Account (IRA) before age 59 1/2. They make an exception on distributions up to $10,000 for a first home purchase.
To qualify, it’s important to know how the IRS defines a first time homebuyer. According to IRS Publication 590-B, a first time homebuyer is defined in the following way:
Generally, you are a first time homebuyer if you had no present interest in a main home during the 2-year period ending on the date of acquisition of the home which the distribution is being used to buy, build, or rebuild.
The IRS goes on to say that a spouse also has to meet the above definition to qualify. If both spouses meet the above definition, each of you may withdraw up to $10,000 from your respective IRAs. In other words, you could distribute up to $20,000 total from your IRAs to buy, build, or rebuild a home. Elsewhere in the tax code, the IRS refers to a main home as one’s principal residence, or the home you live in most of the time during a given tax year. Consequently, this carve-out for a first home purchase won’t work for an investment property or vacation home.
Remember, the only provision here is that there is no 10% early withdrawal penalty. Generally, the 10% penalty applies when money is distributed from an IRA before age 59 ½. Money withdrawn from an IRA is still taxable at ordinary income tax rates. There is no getting away from paying taxes!
Up until now, I’ve only discussed tapping your Traditional IRA for a first home purchase, but you may have other options. Before disturbing your retirement nest egg, I would exhaust at least two other options first, in no particular order:
1. Take Out a 401k Loan
If you or your spouse has a 401k through your employer, you may be eligible to loan the money to yourself. While not all 401ks have loan provisions, many do. Your HR person can tell you plan provisions for the loan repayment period, the amount you can loan out, and the loan interest rate. Of course, any interest on the loan would be paid to yourself within the 401k, not to a third-party, and rates are reasonable. The main differences between a 401k loan and an IRA distribution are that the 401k loan is not taxable, you’re “forced” to repay the loan in a 401k with interest, and you can use the funds for any purpose you choose.
2. Take out a HELOC
Speak with a qualified mortgage broker about your down payment options. If you have good credit and perhaps some cash you’d like to keep at the bank, you may be eligible for a home equity line of credit (HELOC) on a large portion of your down payment. This loan is in addition to the mortgage. Though borrowing more money may seem daunting, this could be a smart move. If you decide to take out a HELOC for the down payment, you’ll be taking advantage of historically low rates (2020), preserving your emergency fund, and keeping your retirement next egg intact for the future.
As with a 401(k) loan, you won’t owe any taxes with a HELOC. Yes, you’ll need to pay back the HELOC, but consider the difference between how much interest you’ll pay with a HELOC vs. how much you’ll pay in taxes with an IRA distribution. Besides, if your mortgage and HELOC together are under $750,000, the interest is deductible if you can itemize. One more thing: if your cash, or cash and the HELOC combined, make up a down payment of 20% or more then you can avoid the additional cost of mortgage insurance. Bottom line: you’ll keep the rest of your financial plan intact all while you enjoy your new home.
Are you planning a job change and you need a down payment? If so, rather than roll your old 401(k) into the new employer's plan you may want to consider moving it to an IRA simply to make $10K of it available for a first home purchase distribution.
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