Should You Dip into Your IRA to Buy a First Home?

Dear Carrie,

I have a friend who said that she used part of her IRA to buy her first home. Is that legit? And if so, will I have to pay a penalty? I’m only 30 years old.

—A Reader

Dear Reader,

As prices (and down payments) for homes continue to escalate across the country, this is a great question. And the quick answer to your question is yes—the IRS does allow penalty-free withdrawals of up to $10,000 of IRA funds for first-time homebuyers.

However, as enticing as this may be, taking that withdrawal comes with certain caveats you need to carefully consider—not only to avoid taxes and penalties, but perhaps more importantly, to make sure you're not jeopardizing your future financial security.

I'm always a little uncomfortable when people want to pull money out of their retirement accounts early for whatever reason, even if the IRS thinks it's okay. But before we get into those concerns, let's talk about the facts.

Who's considered a 'first-time' homebuyer

While IRA withdrawals before age 59½ usually trigger a 10% penalty, there are exceptions—including the first-time homebuyer exemption. Making it even more tempting, the definition of a first-time homebuyer is broader than it sounds.

It applies to your very first home purchase, of course, but it also applies if you or your spouse haven't owned a principal residence at any time during the past two years. The operating word here is 'principal', because even if you've owned a vacation home during that time, the exemption can still apply.

Also, you yourself don't have to be the homebuyer. You can also qualify for the exemption if you're helping your spouse, child, grandchild or parent buy a home.

What you can withdraw

What's not so appealing is the limited amount you can withdraw. The maximum lifetime penalty-free withdrawal from an IRA under the homebuyer exemption is $10,000. While that's a good chunk of money, it may not make much of a dent in your down payment if you live in an area where property values are high.

That $10,000 limit is an absolute if you have a tax-deferred account like a traditional IRA. However, if you have a Roth IRA, you may have a little more leeway; you can always withdraw contributions to a Roth tax- and penalty-free. However, if you withdraw earnings from your Roth, you're subject to the $10,000 limit. 

In addition, you and your spouse can qualify individually for the homebuyer exemption, potentially allowing a couple to withdraw up to $20,000 penalty-free.

Taxes you may have to pay

You may be thinking all this is very generous of the IRS, but it's not that simple. The homebuyer exemption is penalty-free, but not necessarily tax-free. Again, the rules are different for traditional and Roth IRAs.

With a traditional IRA, withdrawals are subject to ordinary income taxes—even the $10,000 withdrawal for a first home. With a Roth, withdrawals of contributions are always tax-free because you've already paid income taxes on that money. So are withdrawals of earnings of up to $10,000 under the homebuyer exemption, assuming you've had the Roth for five-plus years. If you've had the Roth for fewer than five years, you'll pay taxes on the earnings withdrawal. And if you withdraw more than $10,000 in earnings, that money will be subject to both ordinary income taxes and the 10% penalty.

As you can see, it can get complicated. If you've converted assets from a traditional IRA to a Roth, there's even more to consider. Best to consult your tax advisor.

What you can use the money for—and when

Once the money is in your hands, the IRS wants to make sure you use it for the purpose intended. So the funds must be used for what is defined as qualified acquisition costs—the cost of buying, building or rebuilding a home plus any usual or reasonable settlement, financing or other closing costs.

In addition, the funds must be used within 120 days of receiving the distribution.

The bigger retirement savings question

Being able to take money from your IRA for a down payment is one thing—whether it's the right thing for you is another. I caution you to think carefully. Raiding your retirement account can have long-term consequences. You're losing the tax-free growth over time, and you're depleting something that you've worked hard to save. Look at the big picture and talk to your financial advisor. Make sure you're doing the right thing not only in terms of present taxes and penalties, but also in terms of your future security.

Have a personal finance question? Email us at askcarrie@schwab.com. Carrie cannot respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries, contact Schwab.

Please note: This article may contain outdated information about RMDs and retirement accounts due to the SECURE Act 2.0, a law governing retirement savings (e.g., the age at which individuals must begin taking required minimum distributions (RMDs) from their retirement account will change from 72 to 73 beginning January 1, 2023). For more information about the SECURE Act 2.0, please read this article or speak with your financial consultant. (1222-2NLK)