With home prices up more than 20% over the past 12 months, first-time buyers looking for additional funds to cover their down payment may be wondering, “Can I borrow from my IRA to buy a house?” The short answer is yes, up to a certain amount. You can withdraw from your IRA without penalty due to a first-time homebuyer exemption. However, there are some important rules that apply.
While taking advantage of this exemption may be tempting, it’s important to consider its impact on your future, especially the valuable tax-advantaged compounding earnings you’ll be missing in your retirement account by taking an early withdrawal.
Here are three reasons why borrowing from your IRA to buy a house is possibly a bad idea, along with some alternatives to consider. However, it’s always important to consider your particular circumstance while making any financial decision.
1. You Can’t Withdraw As Much As You Might Think
If you’re a first-time homebuyer, you’re probably becoming familiar with how quickly the costs associated with purchasing a home add up. The IRS created a first-time homebuyer exemption that allows account owners to withdraw up to $10,000 from an IRA penalty-free for a down payment or to help build a home.
It might sound like a lot of money, but considering the surging housing prices across the nation, $10,000 might not go as far as you’d think. For example, the average home cost in the U.S. is $374,900, and the average down payment size on a home in the U.S. is 12%. That means that the average down payment is around $44,988. Clearly, $10,000 doesn’t go as far as it once did.
The IRS defines “first-time homebuyer” loosely. You will qualify if you have not owned a principal residence in the last two years. This $10,000 penalty-free withdrawal can also be used to help a child, grandchild, or parent make a down payment if they are a first-time homebuyer. However, it’s important to note that $10,000 is the lifetime limit, meaning you can’t withdraw for a home purchase penalty-free again even if you open a new IRA. Additionally, the money must be put toward the home purchase within 120 days after the withdrawal.
The rules for a Roth IRA are slightly different. If your account is at least five years old, you can withdraw up to the total amount you contributed to the Roth IRA without penalty, regardless of the exemption. For a Roth IRA, the exemption comes into play on the earnings, which if withdrawn before age 59 1/2 would incur a penalty. Under the first-time homebuyer exemption, you can withdraw up to $10,000 from your Roth IRA’s earnings penalty-free.
If you’re struggling to come up with a down payment, it’s important to note there are options other than borrowing from your IRA. We’ll get into those later in the blog.
2. You May Incur Taxes, Depending On Account Age and Type
IRAs were created to incentivize long-term investing for retirement, which is why certain taxes and penalties apply to early withdrawals. If you’re less than 59 1/2 years old and make a withdrawal from a traditional IRA, you’ll pay income tax and a 10% tax penalty. The first-time homebuyer exemption removes the 10% tax penalty, but not the regular income tax you’re required to pay on the withdrawal.
As mentioned earlier, a Roth IRA has slightly different rules. Because a Roth IRA is funded with after-tax dollars, withdrawals from your contributions are tax-free. However, to avoid taxes on your earnings, your account must be at least five years old. So, that means if your account is less than five years old, you will be taxed on your earnings, even if you qualify for the first-time homebuyer exemption. If your account is older than five years, you can withdraw up to $10,000 from your Roth IRA’s earnings tax-free under the exemption. However, it should be noted that the IRS’ ordering rules come into play when assessing the tax effect of a non-qualified distribution. If you haven’t met the five-year rule but need the money for the purchase of a home, then any withdrawal of funds that can be attributed to a contribution or conversion will not be taxed.
3. The Funds You Withdraw Can No Longer Compound Over Time
If you don’t have enough set aside for a downpayment, the first-time homebuyer exemption may seem like a good option, but it’s important to consider your future self and the long-term market returns you’ll be missing out on in your retirement account.
You can only contribute a fixed amount each year to an IRA ($6,000 or $7,000 if you’re age 50 or older). Once you withdraw, you cannot put that money back in. Withdrawing early means that your funds are no longer accruing compound interest, which could set back your retirement investments many years.
As an example, if you left $10,000 in your IRA instead of withdrawing to make a down payment, assuming a modest 7% average annual return, over 30 years that $10,000 would grow to more than $76,000.
Investing as early as you can, even if you can’t max out your IRA, will accelerate your investments over time. This is why dipping into your IRA for a down payment should be a last resort.
Options Other Than Borrowing From Your IRA
If you’re struggling to come up with that last $10,000 for your down payment but don’t want to sacrifice your retirement funds, there are other options.
First-Time Homebuyer Assistance Programs
Before exhausting other options that could have detrimental long-term consequences, ask your real estate agent about first-time homebuyer assistance programs. There are numerous national and local programs that can aid with closing costs, down payments, and interest rates.
In addition, some mortgage lenders only require a 3-5% down payment if you have a credit score above 620 points, though you’ll need to put at least 20% down on the home to avoid having to purchase private mortgage insurance.
If you’re in a pinch, you can borrow from your IRA through a tax-free rollover as long as you return the money to the IRA account within 60 days. If not returned within 60 days, the withdrawal will incur penalties and taxes. Though not highly recommended, this can be a good short-term solution for those who are close to meeting the down payment necessary to avoid private mortgage insurance.
401(k) Loans and Withdrawals
You can access your 401(k) funds for a down payment on a house in two ways, with a loan from your account or a withdrawal.
Loan: A loan will need to be repaid with interest. The maximum loan amount is half of your 401(k)’s vested balance or $50,000, whichever is less. If a loan is not repaid by its due date (generally five years), the balance is subject to a 10% penalty. There could also be complicated tax implications. For example, if you’re terminated or leave your job while you have an outstanding 401(k) loan, you would need to pay it off by that year’s tax filing deadline, plus extensions.
Withdrawal: A withdrawal will be subject to income tax, and in most cases, a 10% penalty. There are some exceptions, but if you have other assets that could go toward the down payment, you likely won’t qualify.
While using your 401(k) to buy a home is allowed, it’s certainly not recommended. Like with an IRA, making an early withdrawal from your 401(k) will cause you to miss out on long-term returns in the market.
Invest in Your Future with Alternative Assets
The home-buying process can be overwhelming for first-timers. Borrowing from your IRA to buy a house may seem convenient at the moment, but it’s important to consider how doing so will affect your future. There are plenty of other options available, especially for first-time homebuyers.
If you’re looking to diversify your current IRA contributions, you may want to consider rolling over some of your funds into a self-directed IRA. Alternative assets have long been a keystone of institutional investors’ portfolios due to their historical high returns. With an Alto IRA or CryptoIRA, you can invest in things you’re interested in-like crypto, real estate, fine wine, farmland, and more.
To start investing in alternative assets with your IRA, open an account today.