How to Use a Roth IRA to Buy a House - But Should You?
How to Withdraw 10k of Tax Free, Penalty Free Earnings From Your Roth
In a previous blog post about whether to invest in a Roth IRA or Traditional IRA I mentioned how a Roth IRA can be a great tool to help pay for your first home. If you already have a Roth IRA, awesome! If you don't and can afford it, I'd recommend investing in one if you are eligible because of the benefits and flexibility down the road.
It's even more important to invest in a Roth IRA if you're young and trying to save for a house. My wife and I chose to invest in a Roth IRA mostly because my college professors recommended it. Coming out of school, I didn't understand the full benefit right away but I soon learned that a Roth IRA can be the most flexible tool in your personal finance tool belt.
"Roth IRA's have the flexibility of a savings account but with many of the advantages of a traditional IRA."
When you fund a Roth IRA you have already paid taxes on the money you invest so you can always take out what you invested. Meanwhile, you are earning a return on that money that grows tax free. Now that you know the Roth can be an awesome investment option, let's look at how you can use it to help buy a house - and should you?
Rules For Using a Roth IRA to Buy Your First House
1. The account has been open for 5 years
You can withdraw what you put into a Roth at any time, but you have to wait 5 years to be eligible to withdraw earnings from your investment for the first time qualified homeowner distribution. If you're looking to use your earnings from a Roth you'll have to have some foresight to start contributing at a young age. That's why its great for young people. It gives you a lot of options when you don't have that much money.
2. Maximum withdrawal = what you contributed + $10,000 of earnings
The maximum you are able to withdraw from a Roth IRA for a qualified first time homebuyer distribution is $10,000 of earnings. It's also important to note that this is a lifetime limit per account owner so once you've used this qualified distribution, that's it.
3. You Must Qualify As A First Time Home Buyer
To be qualified as first time homebuyer it means you have to be buying your first home. However, in a favorable twist of tax law, a first time homebuyer is considered anyone who hasn't owned a primary residence for at least 2 years. If you find yourself in a situation where you've rented for more than two years, you can meet this requirement as a first time homebuyer.
Here is another great post outlining all the Roth IRA first time homebuyer withdrawal rules.
Should You Use Your Roth to Pay For Your house?
Consider Your Overall Asset Allocation
Will withdrawing from your account take all of your investment money? Or do you have a good amount invested in other retirement vehicles to make up for the funds you're taking away from your Roth account. For example, we had ample savings in our traditional IRA and 401k's so we were okay with using the Roth to help fund our house purchase. If the Roth is your only retirement savings, its probably better to try and find another way t0 buy your house.
How long are you going to stay in your house?
If you plan to move soon, I wouldn't plan on using your Roth to fund your house purchase. We used our Roth IRA because we knew we would stay in our house for a long time, maybe forever; so we knew we had time to make up for what we withdrew from the Roth and invest more money into it in the future. If you are planning on moving in 3-5 years, you probably won't have enough time to make up for what you withdrew now.
How much of your home are you paying for?
If you are barely able to fund 1-20% of your home purchase including your Roth, than it's probably better to try to find other means to pay for your house. Houses are expensive and maintaining them can be even more expensive so once you become a homeowner investing in your future can become significantly more difficult. In this case, try to avoid raiding your Roth if you can avoid it. We used some of our Roth funds because it helped us avoid a mortgage. If not, I would have held on to those assets.
What To Do If You Tap Your Roth
Transfer the funds from your account
When we chose to withdraw from our Roth IRA to help pay for our house we needed to make sure we knew what to withdraw. I knew approximately what we had invested but I contacted our broker to make sure I understood the amount I could withdraw. On our tax form we had to to note how much was principle vs earnings (10k). Normally you're broker or whoever holds your Roth IRA will help you make sure you are taking the correct distribution so you don't run into any tax implications come April of that year.
Claim it on your taxes
When we took out the principle, and 10k of tax free penalty free earnings from my Roth, we also had to make sure to claim it on our taxes. Since your distribution meets the requirements for the first time home buyer rules you won't have to pay taxes on any of the distribution. However, the IRS wants to know about it, so make sure you are filling out your taxes accordingly.
This one isn't necessary but it's good to know that you can continue to contribute to your Roth even though you've used it for the first time homebuyer deduction. I've continued to fund my Roth annually since we've bought our house. It's a great way to hedge against taxes in the future. I am also a big proponent of funding tax free retirement accounts first, so I'd also make sure you're at least putting in the company match to reap those benefits.