Brill's Mutual Funds Interactive(R) -- Features

IRAs and Homebuying

By Clifton Linton
Senior Writer, mPower

The good news: You're allowed to take money out of your IRA penalty-free to buy a house. The bad news: there's a lifetime limit of $10,000 and you still have to pay taxes on it.

If you're in the market to buy a home and wondering how you're going to scrape together a down payment, you may be eyeing your IRA. But, for a number of reasons, many financial planners would probably advise you to look elsewhere first.

In addition to the money you'll pay in taxes on the entire sum you withdraw, you'll also reduce your retirement savings account by that amount. Here's the lowdown on using your IRA to buy a house.

IRA Withdrawal

In 1997, Congress made it possible for traditional IRA holders to make a lifetime withdrawal of up to $10,000 for a first-time home purchase. This withdrawal is exempt from the 10 percent early withdrawal penalty but it isn't exempt from state and local taxes. Further, this withdrawal may be used by you or a relative, such as a spouse, child or grandchild.

Why did Congress do this? To help level the playing field between IRAs and defined contribution plans because most 401(k) and 403(b) plans allow participants to take loans. And, since a large number of 401(k) and 403(b) participants roll their balances into an IRA when they change jobs, this provision allows them access to their money for purchasing a home.

A withdrawal of that size likely won't be enough to cover a home purchase but it could be useful in making the down payment. However, you need to be very careful when calculating your money needs. For instance, if you took a full $10,000 withdrawal and earned enough money to be in the 28 percent federal income tax bracket, you would be left with $7,200. And, if your state also collects income tax, you would be left with even less.

"The sage advice is this (money) is a last resort."

— Dennis Filangeri, certified financial planner in San Diego.

Because the tax penalty is so high, many financial planners urge their clients to try to save for a down payment outside of an IRA. You "aren't getting the full value. You will end up paying taxes. It would have been worse than saving the money in a fully taxable account," said Certified Financial Planner Dennis Filangeri of San Diego.

Others offer a simple solution. If you have the discipline to save the money in an old-fashioned savings account where you won't have any annual contribution limits, "my advice is to wait," said Certified Financial Planner Dee Lee, author of Let's Talk Money and The Complete Idiot's Guide to 401(k) Plans.

Using IRA money could have another serious downside: it could keep you from reaching your retirement savings goals. Because this is a withdrawal and not a loan, you can't pay it back like you can with a 401(k) loan, for example. The only way to get the $10,000 that you withdrew back into the account is to make new contributions. Remember that the current maximum annual contribution you can make to an IRA is $2,000. So, it could take you five years just to get back to where you were before you took out the money. And, all that time, you'd lose out on compound interest on the money you withdrew.

You also need to know whether making an IRA withdrawal will push you into a higher tax bracket. If that happens, you could lose even more of the value of your money, Filangeri points out.

"The sage advice is this (money) is a last resort," he said.

Roth Withdrawal

A slightly different and more palatable set of rules governs Roth IRA distributions for home purchases.

You may make a tax-free and penalty-free withdrawal from your Roth IRA providing you have held the account for five years. Currently, no one can make a tax- and penalty-free earnings withdrawal from a Roth IRA because the accounts have only been around since 1998. Those folks who opened a Roth in that year will be eligible to take their first tax- and penalty-free earnings withdrawal in 2003.

You may withdraw all of your contributions, including rollovers, tax- and penalty-free from a Roth IRA.

So, since no one has held an account for that long, there is another option. Regardless of the time that you have held the account, you may withdraw all of your contributions, including rollovers, tax- and penalty-free. However, if you withdraw any earnings you have accumulated in the account, you will have to pay both federal and state income taxes and a 10 percent early withdrawal penalty.

Indeed, one of the nice features of the Roth IRA is that you can order your withdrawals so that you take out only your contributions first.

Ted Benna's Strategy

If you expect to make a withdrawal from a traditional IRA, Ted Benna, creator of the first 401(k) plan and president of the 401(k) Association, offers a strategy to help reduce the tax bite — buy your house early in the year. The reason: You will have paid nearly a full year's worth of mortgage interest and local real estate taxes and you can deduct those expenses from your income. Those deductions may be able to nearly fully offset the taxes and penalty of the withdrawal.

"The point is the earlier in the year you buy, the better," he said.

Do Your Homework

Before you start shopping for a home, do some planning, urges Certified Financial Planner Lee. You should:

Know what you can afford to pay for the house and also each month for your mortgage;
Know where your down payment will be coming from;
Know what other resources you may be able to tap for money; and
Get prequalified for a mortgage so you know how much you can afford (this can be done in a few minutes).

Before you start shopping for a home, do some planning. "Then, you get the ads out."

— Dee Lee, author of Let's Talk Money and The Complete Idiot's Guide to 401(k) Plans.

"Then, you get the ads out," Lee said.

If the prices are scary, think about trimming back your expectations (translation: consider a smaller house).

Before tapping your IRA, try to exhaust all other financial resources (short of going to the local loan shark). Many banks and mortgage brokers offer a variety of low- and no-down payment loans. Also, the Federal Housing Administration offers loan programs tailored to first-time homebuyers and those with limited resources.

The drawback of some of these loans is that you will be financing almost the entire home purchase and/or you may have to pay a slightly higher interest rate — but, you won't have to tap your retirement nest egg.

If none of these options works for you and you decide to tap your IRA, find out how long it will take to get the withdrawal approved by your custodian. You should expect it to take at least a week to get the money. Knowing this information is critical for when you set a purchase closing date.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.