If you’ve been faithfully contributing to your Roth IRA account, the IRS is giving you a bonus: The ability to use funds to build or purchase a new home without incurring taxes or penalties. If you qualify, you can make your homeownership dreams a reality with this special Roth IRA early withdrawal exception that’s about to make your life a bit sweeter.
The Roth IRA homebuyer exception
Roth IRA holders always have the right to withdraw their contributions without penalty or taxes. But your Roth IRA includes both contributions and earnings. Once you’ve taken out all your contributions, withdrawals of earnings before you reach age 59 1/2 are typically subject both to income tax and to a 10% penalty.
However, you’re allowed to withdraw up to $10,000 of the Roth IRA’s earnings for a first-time home purchase and bypass the 10% penalty and taxes. This $10,000 homebuyer exemption is in addition to all the contributions you’ve made. So if you’ve contributed $50,000 to your Roth IRA account over the last ten years, you can take out the entire $50,000 plus the $10,000 homebuyer exemption amount.
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Going beyond retirement
It’s easy to limit the Roth IRA’s exceptional features to a box of benefits exclusively for retirees — after all, it’s an individual retirement account that allows you to contribute money you’ve already paid taxes on, grow your investments over time, and withdraw 100% of your earnings tax-free after you’ve reached age 59 ½.
But the Roth IRA can give you access to your dream life before retirement — using the account to build, rebuild, or buy a home without incurring a 10% early withdrawal penalty on up to $10,000 of distributions received. It’s a phenomenal perk that few aspiring homeowners are aware of.
Beware: Don’t be tempted to exhaust your retirement savings for the sake of a new home. This strategy works best if you already have a cushion for retirement — in a workplace plan or an individual portfolio of investments — that will ensure you can still live your best life in your golden years.
Pay attention to the rules
The Roth IRA early withdrawal exception rules for future homeowners appear to be simple: Be a qualified first-time homebuyer and use the funds to buy or build a home within 120 days of the withdrawal. If you fail to follow the rules, the IRS will treat your distribution as a non-qualified withdrawal that is subject to the typical taxes and penalties.
Of course, most rules aren’t ever as straightforward as you would like them to be. They often require you to go beyond the words you see to make sense of them.
For instance, the first-time homebuyer definition isn’t exactly what you may initially think it is from its name. The home you buy doesn’t actually have to be your first home ever. If you haven’t owned a home within the last two years, you are still considered a first-time homebuyer for purposes of this rule. The same ownership rules apply to your spouse.
Here are a few more pointers to keep in mind when taking distributions under the first-time homebuyer exclusion:
- Must be used to pay for qualified acquisition costs, including the costs of rebuilding a home, financing, and closing costs.
- Must be used to pay qualified costs for a principal residence of the first-time buyer who is your spouse, child, grandchild, etc.
- Total qualifying first-time homebuyer distributions are limited to $10,000 (this is a lifetime limitation that includes prior qualified first-time homebuyer distributions).
Watch out for the five-year rule
The Roth IRA’s $10,000 homebuyer exemption is all yours if you check the box on all the rules above and meet the five-year rule. Basically, you have to wait until the account is five years old (based on the tax year of your first IRA contribution) to avoid paying income taxes on your earnings.
Although you can always take out what you contribute, it’s the earnings on your investments that sound off the alarm in your account and trigger the five-year rule. Let’s say you contribute the maximum amount to your Roth IRA ($6,000 in 2021, or $7,000 if you’re age 50 or over), and your account grows 7% a year. The growth in your account would be subject to income taxes if you don’t adhere to the five-year rule. Also pay attention to the income ranges to ensure you are eligible to contribute every year.
Don’t forget your paperwork
All good things in the tax code require proper documentation if you want to stay on good terms with the IRS. In the year you make a Roth IRA withdrawal for the purchase of a home, you’ll receive a 1099-R from your custodian showing the distribution amount you received from your retirement plan. Then, it’s your turn to show and tell the IRS about your qualified first-time homebuyer distribution on IRS Form 5329 and IRS Form 8606.
Don’t let all these forms bog you down and stop you on your journey. They are all signs of a good thing: You were able to maximize the benefits of your Roth IRA to buy a home. So, enjoy the fruits of your Roth IRA beyond the built-in retirement benefits as you share your good news with the IRS.