Buying a home is a daunting experience for many reasons, not the least of which is the amount of money typically required for a down payment. Buying a home with the best interest rate and avoiding costly private mortgage insurance (PMI) typically requires 20% down. On a $250,000 home, that amounts to $50,000.
Some people may consider withdrawing funds from their Roth individual retirement account (IRA). Unfortunately, you can’t take money out of an IRA without paying taxes and a 10% penalty until you reach the age of 59½ and have had the account for five years, also known as the five-year rule. You can’t, that is, unless you qualify for an exception. Here’s what you need to know about preparing for an exception that allows you to use funds from your Roth IRA tax and penalty-free to purchase a home.
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Why use a Roth IRA to buy a home?
Although Internal Revenue Service (IRS) rules allow you to take money out of almost any retirement savings account to purchase a home, the Roth IRA has some advantages over others. Since your contributions to a Roth account are after-tax, you can withdraw that money anytime for any reason with no penalty. If you qualify for an exception, you can also remove earnings tax and penalty-free.
Qualified home purchase withdrawals from accounts that include pre-tax contributions (such as a traditional IRA) let you off the hook on the 10% penalty, but require you to pay taxes on the entire withdrawal since you didn’t originally pay taxes on that money.
Withdrawing money from your Roth IRA means you will miss out on future earnings and growth, making this move ill-advised for most people. However, if you have substantial retirement savings from a workplace 401(k), traditional IRA, or other retirement accounts, using proceeds from a Roth IRA to buy a home might make sense.
Who qualifies for the IRA exception?
The requirements to receive an exception for early distribution of funds differ for a traditional and Roth IRA. In both cases, you must be a first-time homebuyer as defined by the IRS: someone who hasn't owned a principal residence anytime in the past two years.
The traditional IRA exception
If you qualify as a first-time homebuyer, you can withdraw up to $10,000 penalty free from your traditional IRA and use the money to buy, build, or rebuild a home before the age of 59½. If both you and your spouse qualify as first-time homebuyers, you can withdraw up to $20,000.
Despite avoiding the 10% early withdrawal penalty, you'll still owe income tax on any amount you (and your spouse) withdraw. Also, that $10,000 ($20,000) amount is a lifetime limit. You won't get to use the first-time homebuyer provision again to buy a home, even if you use a different IRA.
The Roth IRA exception
The rules are different for a Roth IRA. For starters, you can withdraw contributions you’ve made to your Roth IRA tax- and penalty-free at any time, for any reason. Only earnings are subject to the exception rules.
If you use the money to buy a first home, you can also withdraw earnings penalty-free (but not tax-free) from your Roth IRA before the account is five years old (and before age 59½). If you take out earnings for a first-time home purchase after five years, you will owe no penalty or taxes, even if you are under 59½. As with a traditional IRA, early withdrawal of earnings from a Roth IRA is subject to a $10,000 ($20,000) lifetime limit.
Roth IRA withdrawal rules
You can withdraw contributions and earnings from your Roth IRA penalty- and tax-free if you are 59½ or older and have had your account for at least five years. If you are 59½ or older but have not had your account for at least five years, you can withdraw contributions tax- and penalty-free, but earnings will be subject to taxes.
If you are under 59½ and your account is five years old, the distribution of contributions is tax- and penalty-free but earnings may be subject to taxes. If your account is under five years old, contributions are tax- and penalty-free, but profits are subject to taxes and a penalty—unless you are a first-time homebuyer.
| Roth IRA Distributions | Under age 59½ | Under age 59½ (1st time homebuyer) | Age 59½ or older |
|---|---|---|---|
Contributions < 5 years old | No taxes; No penalty | No taxes; No penalty | No taxes; No penalty |
Earnings < 5 years old | Yes taxes; Yes penalty | Yes taxes; No penalty | Yes taxes; No penalty |
Contributions > 5 years old | No taxes; No penalty | No taxes; No penalty | No taxes; No penalty |
Earnings > 5 years old | Yes taxes; No penalty | No taxes; No penalty | No taxes; No penalty |
How to use your Roth IRA to buy a home
To avoid getting hit with taxes or unexpected penalties when making an early Roth IRA withdrawal for a home purchase, follow these steps:
Factor in the five-year rule
When using a Roth IRA to help fund your first home, the five-year rule is more important than your age. The first-time homebuyer exception lets you withdraw earnings with no taxes or penalty as long as your account is five years old. Your age doesn’t matter. If your first Roth account is a converted account, the five-year clock begins on the conversion date.
Choose investments with your timeline in mind
If you expect to use your Roth IRA to help fund a home purchase, your investments should match your timeline. If your timeline is five years or less, you may want your investments to include more bond funds than stocks. If it’s longer, you may have time to take on more risk. As always, speak to a trusted financial advisor before choosing your asset mix. If you are looking for an advisor, WiserAdvisor lets you compare top firms matched to your needs.
Contribute as much as you can
No matter how many years you have before you plan to dip into your Roth IRA, make sure you maximize your contributions so you have the greatest amount of funds available when the time comes. The maximum contribution you can make for 2023 is $6,500 ($7,500 if you are 50 or older). Keep income restrictions in mind since high-income individuals are limited in the amount they can contribute—or whether they can contribute at all. Finally, make sure you make maximum contributions in your other retirement accounts, such as your workplace 401(k).
Purchase your home
Once you have enough saved in your Roth IRA, and your account is at least five years old, you’re good to go and can withdraw all of your contributions and up to $10,000 (your lifetime limit) in earnings tax and penalty-free to help you buy your dream home.
Is it a good idea to use a Roth IRA to buy a home?
Even though you may meet the requirements to use your Roth IRA to buy your first home, doing so may not be the best way to make the purchase. The primary purpose of an IRA is to save for retirement. Even if you purposely open a Roth IRA for a home purchase, there are better alternatives (see below).
If you are already saving a lot for retirement in a 401(k) or other retirement savings account, using a Roth IRA is better than tapping into your traditional IRA since your tax burden will likely be lower with the Roth account.
If the only way you can acquire a down payment is by taking it out of your Roth IRA—ask yourself whether you are stretching yourself too thin financially to buy a home.
Alternatives to a Roth IRA to buy a home
Given the opportunity cost of using retirement funds to buy a home, make sure you’ve exhausted other funding sources before turning to your Roth IRA. Consider any of the following.
Delay home purchase
Ask yourself what happens if you wait a year or two or three. Perhaps a delay would give you time to save enough for a down payment without touching your retirement account.
Lower housing expectations
Your first home will likely not be your last. The term “starter home” exists for a reason. Consider a fixer-upper, a smaller house, or one in a more affordable neighborhood.
Take out a 401(k) loan
Most 401(k) plans let you borrow $10,000 or half your vested amount (whichever is higher) up to $50,000. Your provider sets the interest rate and term, often up to five years. If you have lost track of an old 401(k) or IRA, consult financial concierge, Beagle, to unlock these plans.
Family loans or gifts
It is often uncomfortable to ask your family for money in the form of a gift or loan, but if they can help, it may be worth seeking their assistance. If you get a loan from family, treat it like any other debt and pay it off on time.
High-yield savings accounts
Putting money into a high-yield savings account may get you the amount you need faster than you think. High-yield savings can give your down-payment fund a big boost.
Selling non-retirement investments
Another way to side-skirt the use of retirement funds is to sell stocks or other investments that are not part of your retirement portfolio. This type of action requires advice from a trusted source such as financial services platform Empower.
First-time homebuyer programs
First-time homebuyer programs at the federal, state, and local levels can often help cover closing costs and at least part of your down payment. Ask your real estate agent about programs available in your area.
Low-down payment loans
Not all home loans require 20% down. You can get a fixed-rate conventional loan for as little as 3% down, although you must pay for private mortgage insurance (PMI) along with your monthly payments. If you qualify for a Veteran’s Administration (VA) loan, you may be able to avoid a down payment entirely with no PMI. FHA and similar loan programs offer low down payment options with a less expensive type of mortgage insurance called MIP.
TIME Stamp: The first-time homebuyer exception is the key
The first-time homebuyer exception is the key to using funds from your traditional or Roth IRA to purchase a home. Technically, a first-time homebuyer has not owned a house within the past two years.
Complicated rules determine whether you will pay taxes, a 10% penalty, both, or nothing when you take money out of your IRA. Using a Roth IRA is not considered the best way to fund a home purchase, primarily because of the lost opportunity to grow the funds inside the IRA to use as future retirement income.
Frequently asked questions (FAQs)
How can I borrow from my IRA without penalty?
You can’t borrow money from an IRA, at least in the sense most people think of a loan. You can withdraw funds from your IRA, use the money, and put it back in within 60 days to avoid taxes and a penalty.
What is the 5-year holding period for Roth IRA?
If you withdraw earnings (not contributions) from your Roth IRA before it is at least five years old, the amount withdrawn may be subject to taxes and a 10% penalty depending on your age or the reason for the withdrawal. If you are 59½ or older, the money will be subject to taxes only. The same is true if you are under 59½ but planning to use the money to buy a first home.
Can I borrow from my IRA for 60 days?
While it is technically called a rollover (not a loan), withdrawing funds from your IRA and replacing them within 60 days without penalty or taxes is possible.
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