The Hidden Cost of Using an IRA to Buy a Home

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The IRS will let you do it, but that doesn’t mean it’s a good idea.

Such is the case when it comes to using an IRA to help pay for buying a home, according to financial experts. 

If you’re younger than 59 ½, pulling money out of an IRA (which stands for individual retirement account) often comes with a 10% tax penalty. But the IRS makes an exception for certain homebuyers. This loophole might make it tempting to use retirement funds to finance a down payment or other upfront mortgage costs. 

Here’s what to consider before you do that.

Should You Use Your IRA Funds to Buy a Home?

Whether you can use your IRA to buy a home and whether you should are two different questions. The financial experts we spoke with recommend leaving those funds where they are and looking for alternatives. 

“For most people, using money from an IRA to pay for a home shouldn’t be your first option,” said Joe Calvetti, a CPA and the founder of Still River Financial Planning, a financial planning firm. 

Any money you withdraw from your IRA early won’t have the opportunity to grow and compound over time. As a result, you’ll have less money left to provide for a comfortable retirement, and a lower likelihood of achieving financial independence. Before using your IRA to buy a home, run the numbers to ensure you’re still on track to reach your retirement goals.

“Consider how much you have saved for retirement, and how that aligns with your goals,” Calvetti said. “And think about other sources of funding that may be available, and whether some extra money from a retirement account is really necessary.”

Pro Tip

Before using your IRA to buy a home, consider what other alternatives are available, including taking more time to save up or using a smaller down payment.

Buying Real Estate With an IRA

That being said, there do exist some incentives and exceptions for people who want to use IRA funds to buy a home. The right option for you depends on the type of IRA you have and what you plan to use the home for.

Homebuyer Exception

The IRS offers an exception that allows you to withdraw funds from your IRA to fund the purchase of a home. You can withdraw up to $10,000 to buy, build, or rebuild your first home. This withdrawal won’t be subject to the 10% penalty, but depending on the type of IRA you have, it could be subject to income taxes.

“The nature of the traditional IRA versus the Roth IRA can mean different tax treatments for the withdrawal,” Calvetti said.

If you withdraw the $10,000 from your Roth IRA, you won’t have any additional tax liability as long as it’s been at least five years since you opened the account. Because your contributions were taxed, qualified withdrawals from these accounts are tax-free in this exception.

If you withdraw the funds from a traditional IRA, then you’ll pay income taxes on the money. Traditional IRA contributions are made with pre-tax dollars, meaning the IRS still has to get its share before you can use it for your home purchase.

Roth IRA Contributions

If you have a Roth IRA, you may be able to use the money in it to pay for your home without relying on the IRS’s first-time homebuyer exception. Because your Roth IRA contributions have already been taxed, the IRS allows you to withdraw them tax-free and penalty-free at any time once the account has been opened for at least five years. 

Keep in mind that this exception only applies to your Roth IRA contributions, not your earnings. For example, if you contributed $6,000 to a Roth IRA several years ago and it’s grown to $7,500, you can only withdraw the original $6,000 penalty-free unless you’re using the IRS first-time homebuyer exception.

Self-Directed IRA

The final way you can buy real estate with your IRA is by using a self-directed IRA. This type of account allows you to purchase a wider variety of assets, including alternative assets and physical assets like property.

When you buy real estate with a self-directed IRA, you don’t actually have to withdraw the funds from your account. Instead, the property is a part of your retirement portfolio. However, unlike the other options we’ve mentioned above, you can’t actually live in the home.

“The property, unfortunately, can’t be used by your family in any way and must operate strictly as an investment, a detail many people are not aware of,” said Kelly Klingaman, a CFP and the founder of Kelly Klingaman Financial Planning.

Who Qualifies for the IRA Exception?

To use the IRS’s first-time homebuyer and withdraw $10,000 for your home purchase, you’ll have to meet a few different requirements. First, you can only use the money for qualified acquisition costs, which include the cost of building, buying, or rebuilding the home, as well as any costs related to financing or settlement.

To qualify as a first-time homebuyer, you (and your spouse, if you have one) must not have owned a home during the previous two years.

It’s worth noting that if you’re married, both you and your spouse can withdraw $10,000 from your respective IRAs without having to pay the 10% penalty. However, this exception can only be used once. If you’ve previously withdrawn $10,000 for a home purchase, you can’t do so again.

Alternatives to Using an IRA to Buy a Home

It can be tempting to use the money in your IRA to buy a home, especially if you’re starting from square one otherwise. 

“I completely understand the temptation to use the first-time homebuyer exemption for an individual or family that’s emotionally ready to buy their first home,” says Klingaman.

But despite the various loopholes available to help you do so, experts recommend leaving your retirement funds where they are and instead looking for alternatives.

As a first step, Klingaman recommends coming up with a savings plan for the next 6-12 months. Your family’s income and expenses will dictate how much you can save in that time, but it may be worth making short-term sacrifices in your spending to save the money more quickly.

“There are a lot of behavioral aspects at play in making the savings plan work over time, and I find that a combination of coaching clients and holding them accountable for monitoring their own cash flow on a weekly or monthly basis helps support consistency in changing habits that gets them to their savings goal,” Klingaman said.

When it comes to where to keep the money you’re saving, Klingaman and Calvetti both recommend a high-yield savings account, especially if you’re planning to buy a home within the next few years. If you’re saving for a home purchase in the far distant future, such as your dream home in five or more years, you might consider a taxable brokerage account to help your money grow even more.