The IRS allows you to withdraw contributions from your Roth IRA penalty-free to buy your first home, plus up to $10,000 of earnings. But most financial advisors would recommend tapping into your retirement savings only as a last resort. Luckily, you have plenty of alternatives. Here’s what you need to know to determine whether using your Roth IRA as a first-time homebuyer is the right move for you. Consider working with a financial advisor as you explore home ownership.
Using Your Roth IRA to Purchase a Home
As mentioned earlier, you can withdraw all your contributions to your Roth IRA, plus up to $10,000 worth of investment earnings, penalty- and tax-free, to help you purchase your first home. But you must meet the following requirements:
- You and your spouse are first-time homebuyers (the IRS defines this as someone who hasn’t owned a principal residence in the past two years).
- Your Roth IRA has been open for at least five years counting from January 1 of the year you made your first Roth IRA contribution.
- You use the funds toward purchasing a home within 120 days of receiving the distribution.
Now, you’re probably wondering what we mean by investment earnings. To understand this concept, it’s helpful to view your Roth IRA as savings spread across two buckets. The first bucket contains your contributions. This is the money you put into the plan. The IRS lets you collect from this bucket at any time for any reason without penalty or taxation.
The next bucket holds your investment earnings. This is the money your contributions earned through the stock market or via interest and other gains.
So if you’ve amassed what you need to purchase a home with your contributions alone, you can tap into it without having to meet the rules stated above. Otherwise, you can fill the gap, up to $10,000, with your investment earnings as long as you follow those rules.
If you and your spouse qualify as first-time homebuyers and have Roth IRAs, you can together put a total of $20,000 ($10,000 x 2) worth of earnings toward purchasing a home. You can withdraw that money penalty-free to cover most costs associated with buying a home. This includes down payments and closing costs.
In addition, you can use that money toward purchasing the first home for your children, grandchildren or parents.
To cover your bases, though, we recommend consulting a tax expert or your financial advisor for more information about what qualifies as home acquisition costs in the eyes of the IRS.
Should You Use Your Roth IRA to Buy a Home?
Purchasing your own home is probably one of the biggest investments you’ll ever make. If you’ve been saving for retirement, it’s tempting to raid your Roth IRA for the down payment or to cover closing costs. But doing this should be your last resort. Taking money from your Roth IRA now, even if you won’t face an early-withdrawal penalty, means you take two hits. First, you shave off a chunk of what you’ve already saved and is growing tax-free. Second, you miss out on compounding interest potential.
How much are you potentially losing? You can calculate compound interest using the formula, A=P(1+r/n)nt. A is the amount you have after compounding. The value P is the principal amount you are withdrawing. The value r is the interest rate (expressed as a decimal), n is the number of times that interest compounds per year (for simplicity, choose once) and t is the number of years (until retirement).
Does the total seem large to you? If yes, you may want to leave your Roth IRA alone and look elsewhere. You also ant to consider how much house you can afford.
You can also make a decision based on the interest rate environment and stock market projections. Most financial advisors suggest you can expect a 6% to 7% annual return on retirement investments heavily situated around equities. That’s a conservative estimate. Since 1982, the S&P 500 has returned an average of 10%.
So in a low interest rate environment, you may benefit more by borrowing more and having larger mortgage payments. In such a case, the long-term gain from your Roth IRA is more beneficial than the the smaller interest payments you’d be making toward a mortgage.
Alternatives to Tapping Into Your Roth IRA
You can take plenty of steps to cut down on the costs of home buying. If you haven’t owned a home in the last two years, you may qualify for one of many first-time homebuyer programs. Some of these cater to people meeting specific income limits, who work in certain professions or who wish to live in designated areas.
If you don’t qualify for one, consider a government-backed loan. The interest rates for these can dip as low as 3%. They also generally have less strict requirements than conventional mortgages. For example, a Federal Housing Administration (FHA) loan comes with a down payment as low as 3.5% if you qualify. Those tied to conventional mortgages climb to around 20%.
You may also qualify for the following government-backed options:
And if you don’t qualify for any of these, you can always search for local first-time homebuyer programs or compare mortgage rates on conventional options. To get favorable rates on the latter, you’d need a good credit history. So you may want to take a step back and boost your savings while paying off debt. In the long run, you’d find yourself closer to financial wellness.
You can always withdraw your contributions to a Roth IRA. And you can tap up to $10,000 from your Roth IRA earnings to purchase a home if you haven’t owned one in the last two years and you’ve had your Roth account been for at least five years. But should you? Many, if not most, financial experts would say no. The lost gains are generally not worth it, long term. But all situations are different. A financial advisor can help you make the best call.
Tips for Saving up for a Home
- Instead of raiding your Roth IRA to cover a down payment, wait until you’ve saved enough. Consider opening a high-yield savings account and making automatic transfers into it. You can also explore the best money market accounts and certificates of deposit (CDs) with the best CD rates.
- Shoring up the finances to buy a home can be complex and daunting. But you don’t have to go it alone. A financial advisor can be invaluable in this process. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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