Buying a home is one of the biggest financial decisions most of us will ever make. If you're a first-time homebuyer, you're likely exploring every possible way to gather the funds for your dream house. One option that might have crossed your mind is a Roth IRA withdrawal for home purchase. But is it a good idea? And if so, how does that work?
In this article, we'll cover everything you need to know about using a Roth IRA for a home purchase.
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First things first: how does a Roth IRA work?
A Roth IRA is a retirement account where you can contribute after-tax money after paying taxes on it. The main advantage is that your investments grow tax-free, and withdrawals during retirement are also tax-free, as long as you meet certain criteria, such as age and account duration requirements.
Understanding the rules for Roth IRA withdrawals
The IRS has some pretty strict rules regarding when and how you can take money out of your Roth IRA without facing penalties. This is a long-term savings vehicle intended for retirement. Generally, you need to be 59½ years old and have held the account for at least five years to make penalty-free withdrawals of earnings—any interest, dividends, and gains accumulated in the account.
But there's also some flexibility with Roth IRAs: You can withdraw your contributions at any time without penalties or taxes since you've already paid taxes on that money.
What happens if you're eyeing that Roth IRA balance to fund a home purchase? Here’s where things get interesting.
Can I use my Roth IRA to buy a home?
Yes, you can use your Roth IRA to buy a home, and there’s even a special provision in the tax code that allows you to take out up to $10,000 of earnings without penalty if you’re a first-time homebuyer (defined as someone who hasn’t owned a home in the last two years).
This exception can be a game-changer if you're short on cash for a down payment. Just keep in mind that if you withdraw more than $10,000 in earnings, you may be subject to taxes and penalties on the amount over the limit. You must calculate carefully how much you need and whether it’s worth dipping into your retirement savings.
Roth IRA for first-time home buyer: An example
Let’s say you’ve been contributing to your Roth IRA for several years, and you’ve accumulated $50,000 in contributions and $20,000 in earnings. You find a house you want to buy, and you need an extra $15,000 for the down payment.
Legally, you can withdraw your $50,000 in contributions without penalties, and you can take out an additional $10,000 of your earnings under the first-time homebuyer Roth IRA exception. So withdrawing $15,000 to cover your down payment shouldn’t be a problem. That leaves you with $55,000 remaining in your Roth IRA, to continue to grow for your retirement.
Is taking money from your Roth to buy a first home worth it?
While it’s tempting to use your Roth IRA to buy a home, doing so could have long-term consequences for your retirement savings. Every dollar you withdraw now is a dollar less that will grow tax-free for your future. Plus, if you withdraw more than just your contributions, you may miss out on years of compound interest.
“If you need to dip into retirement money for the home purchase, it may signal you're stretching your budget too thin for this home,” says Andrew Gosselin, a certified public accountant and Chief Financial Strategist at The Calculator Site.
So, how can you be sure a Roth IRA withdrawal for home purchase is a good idea for you?
“Review your current retirement projections and projected expenses in retirement,” Gosselin says. “If you have sufficient savings across other accounts like 401(k)s, the Roth withdrawal may be manageable without derailing your goals. But a major withdrawal could require delaying retirement or adjusting your future lifestyle expectations.”
Pros and cons of using a Roth IRA for home purchase
Consider how withdrawing from your Roth IRA for a home purchase might impact your retirement plans. Before making a decision, weigh the pros and cons carefully.
Pros:
- Tax-free withdrawals: Since Roth IRA contributions are made with after-tax dollars, your qualified withdrawals, including those for a first-time home purchase, are generally tax-free.
- No early withdrawal penalty: If you meet certain conditions, you can withdraw up to $10,000 of earnings from your Roth IRA penalty-free for a first-time home purchase.
Cons:
- Impact on retirement savings: “You'll have less saved for retirement since that money can no longer grow tax-deferred over time,” Gosselin says.
- Missed growth potential: By taking funds out of your Roth IRA early, you miss out on the potential compound growth those funds could have generated over time. “This lost growth from compound interest is an ‘opportunity cost’ that can significantly impact your nest egg down the road,” Gosselin says.
- Strict rules: While you can withdraw contributions at any time, accessing earnings requires you to follow strict IRS rules, and failing to meet these can result in taxes and penalties.
Are there other best ways to source the money to buy a house?
If you're hesitant about using your Roth IRA, there are other ways to come up with the funds for a home purchase. You might consider taking out a traditional mortgage with a lower down payment or exploring first-time homebuyer programs that offer assistance with down payments and closing costs. Borrowing from a 401(k) or taking out a personal loan are other options, though each comes with its own risks.
Roth IRA and home purchase: key takeaways
Using your Roth IRA to buy a home is an option that could help you achieve your dream of homeownership, especially if you're a first-time buyer. However, it's essential to consider the long-term impact on your retirement savings and whether there are other, less costly ways to finance your home purchase. Before making any decisions, consult with a financial advisor to determine the best course of action for your unique situation.