How to Use an IRA for a House Down Payment

Individual Retirement Arrangements, or IRAs, are savings vehicles intended to help people prepare for retirement. The funds are subject to rules that discourage early use, often imposing a penalty on withdrawals made before retirement age. While these accounts are structured for long-term growth, federal tax law provides specific allowances for accessing the money sooner without incurring the usual penalties, such as for the purchase of a home.

The First-Time Homebuyer Exception

The Internal Revenue Service (IRS) provides an exception that allows for a penalty-free withdrawal from an IRA to buy a home. The benefit of this exception is the waiver of the standard 10% early withdrawal penalty that applies to distributions taken before age 59½. It is important to note that this only removes the penalty; it does not eliminate the potential for income tax on the withdrawn amount.

This exception has a monetary cap. An individual can withdraw a lifetime maximum of $10,000 penalty-free for a first-time home purchase. If two spouses each have their own IRAs and both qualify as first-time homebuyers, each can withdraw up to $10,000, for a combined total of $20,000 toward the home.

The IRS definition of a “first-time homebuyer” is broader than the term suggests. A person qualifies if they have not owned a principal residence at any point during the two-year period ending on the date the new home is acquired. If married, the individual’s spouse must also meet this two-year look-back requirement. The rules also permit you to make a penalty-free withdrawal to help your spouse, child, or grandchild buy their first home, as long as they meet the qualifying definition.

Withdrawal Rules for Different IRA Types

The tax implications of using the first-time homebuyer exception depend on the type of IRA you hold. While the $10,000 penalty waiver applies broadly, the income tax treatment varies between Traditional and Roth IRAs.

For a Traditional IRA, any distribution is considered taxable income. Because contributions to a Traditional IRA are often made with pre-tax dollars, the entire amount of the distribution is added to your ordinary income for the year of the withdrawal and taxed at your marginal tax rate. The first-time homebuyer exception prevents the additional 10% penalty on top of this income tax.

The rules for a Roth IRA can be more advantageous. Contributions to a Roth IRA are made with after-tax money, so you can withdraw your direct contributions at any time, for any reason, completely tax-free and penalty-free. The homebuyer exception specifically applies to the earnings in your Roth IRA.

You can withdraw up to $10,000 of earnings from your Roth IRA without the 10% penalty under this exception. However, for those earnings to also be free from income tax, the Roth IRA must meet the five-year holding period. This rule requires that five years have passed since the beginning of the tax year for which you made your first contribution to any Roth IRA. If you withdraw earnings before this five-year period is met, the earnings will be penalty-free but subject to income tax.

Required Documentation and Tax Reporting

A regulation known as the 120-day rule mandates that the withdrawn funds must be used for qualified acquisition costs within 120 days of receiving the distribution. These costs include the purchase, building, or rebuilding of a principal residence, as well as associated financing and closing costs. If the home purchase falls through, you can roll the money back into an IRA within this 120-day window to avoid taxes and penalties.

After you take a distribution, your IRA custodian will send you Form 1099-R. This form reports the withdrawal to you and the IRS and may be marked with a distribution code that indicates an early withdrawal, without the custodian knowing if you qualify for an exception.

When you file your annual income tax return, you must file Form 5329 to claim the exception. On this form, you will enter the amount of the withdrawal and use exception code 09 to indicate it was for a first-time home purchase. For those with Roth IRA distributions, Form 8606 is used to report the distribution and track the basis of contributions versus earnings.

The Withdrawal Process

The first step to access your IRA funds is to contact the financial institution that acts as the custodian for your IRA, such as a brokerage firm or bank. Each institution has its own specific procedures and paperwork for processing distributions.

You will need to complete a withdrawal request form, which is typically available online or as a paper document. This form will ask for your personal information, the amount you wish to withdraw, and the reason for the distribution. You will need to specify that the withdrawal is for a first-time home purchase, though the ultimate responsibility for claiming the penalty exception on your tax return lies with you.

During this process, the custodian will present you with a choice regarding tax withholding. You can elect to have federal income tax withheld from the distribution amount. If you opt out of withholding, you will likely need to pay the income tax due on the withdrawal when you file your annual tax return or through estimated tax payments. Once the paperwork is processed, the funds are sent via an electronic funds transfer to your bank account or mailed as a check.