IRA Down Payment Rules: Tax Penalties and Withdrawal Limits

Using funds from an Individual Retirement Account (IRA) for a home down payment is possible, but specific rules and tax consequences must be considered. While IRAs are intended for retirement, the IRS allows exceptions for early withdrawals, including for first-time homebuyers.

Early Distribution Eligibility Criteria

Withdrawing money from an IRA before retirement age typically incurs a 10% penalty, but the IRS provides exceptions under Internal Revenue Code Section 72(t). These include higher education expenses, medical costs exceeding a percentage of adjusted gross income, disability, and first-time home purchases.

The tax treatment of withdrawals depends on the type of IRA. Traditional IRA withdrawals under qualifying exceptions avoid penalties but are subject to ordinary income tax. Roth IRAs offer more flexibility—contributions can be withdrawn at any time tax-free, while earnings may have restrictions. If the account has been open for at least five years, both contributions and earnings can be withdrawn without tax or penalty under qualified exceptions.

First-Time Homebuyer Rules

First-time homebuyers can withdraw up to $10,000 from an IRA without the 10% penalty. This limit applies per person, so a married couple with separate IRAs could access up to $20,000 combined. The funds must be used within 120 days for qualified acquisition costs, including purchasing, building, or rebuilding a home, as well as related expenses like closing costs.

The IRS defines a first-time homebuyer as someone who has not owned a primary residence in the past two years. This rule also applies when purchasing a home for a spouse, child, grandchild, or parent, provided the recipient meets the first-time homebuyer criteria.

While the penalty is waived, withdrawals from a Traditional IRA are subject to ordinary income tax. Roth IRA distributions are tax-free if the account has been open for at least five years. If not, only contributions can be withdrawn tax-free, while earnings may be taxed.

Tax Penalties

Withdrawals outside of permitted exceptions result in a 10% early withdrawal penalty, in addition to ordinary income tax. For example, someone in the 22% tax bracket who withdraws $15,000 early from a Traditional IRA without an exemption would owe $3,300 in federal income tax plus a $1,500 penalty, leaving them with only $10,200.

Early withdrawals also reduce long-term retirement savings by cutting into potential tax-deferred or tax-free growth. A $10,000 withdrawal today could have grown significantly over decades if left invested. Repeated withdrawals increase the risk of outliving retirement savings.

Some states impose additional penalties. California, for instance, adds a 2.5% state penalty on early IRA withdrawals, raising the total penalty to 12.5% before income taxes.

Withdrawal and Reporting Process

To withdraw IRA funds for a home purchase, account holders must request a distribution from their financial institution. Most custodians provide online portals or paper forms where individuals specify the withdrawal amount and reason. Selecting the correct distribution type is critical, as misclassification could trigger an automatic penalty assessment by the IRS.

For first-time homebuyer withdrawals, Form 1099-R, which reports IRA distributions, should reflect Code 2 (early distribution, exception applies) for Traditional IRAs or Code J (early distribution from a Roth IRA) if applicable.

Once received, funds must be used for qualified costs within 120 days. If the purchase falls through or the funds remain unused, the IRS may reclassify the withdrawal as non-qualified, applying penalties and taxes retroactively. Keeping documentation—such as purchase agreements, closing disclosures, and receipts—is advisable in case of an IRS audit.