If you are looking for assets to make a down payment and pay for closing costs on the purchase of a new home, consider tapping into your IRA. First-time homebuyers (see the broad definition below) can use up to $10,000 from their IRA for qualified acquisition costs without having to pay the 10% early-withdrawal penalty to the IRS (note: the penalty could be higher if it is a SIMPLE IRA that is less than two years old). Wisconsin falls in line with the IRS and will not levy a penalty on the first $10,000 either. For a married couple where both spouses are considered first-time homebuyers, each spouse can withdraw $10,000. As a note, if this is from a tax-deferred IRA, the funds will still be subject to income tax.
Who is a first-time homebuyer?
The definition of first-time homebuyer includes more people than the term indicates. As long as you did not have an ownership interest in a principal residence in the past two years, you are generally considered a first-time homebuyer for this exception. If you are married, however, your spouse would also have to meet this requirement for you to be considered a first-time homebuyer.
What can the funds be used for?
The money must be used for qualified acquisition costs: costs of acquiring, constructing, or reconstructing a residence. This also includes usual or reasonable settlement, financing, and other closing costs.
Whom can the funds come from?
This article is written from the point of view that the first-time homebuyer is the person withdrawing the IRA money, which I believe is the most common scenario. That being said, you may be able to withdraw money from your IRA without a penalty even if you are not the person buying the home, and even if you would not be considered a first-time homebuyer.
As long as your withdrawn funds are used to pay qualified acquisition costs for the main home of a first-time homebuyer, the first-time homebuyer can be the following people:
- Yourself
- Your Spouse (remember that your spouse is not considered a first-time homebuyer if you do not meet the requirements, too)
- Your or your spouse’s child
- Your or your spouse’s grandchild
- Your or your spouse’s parent or other ancestor
Lifetime Limitation
Each taxpayer can only withdraw $10,000 over a lifetime before incurring the 10% penalty. This is the case without regard for whom the funds were used. As an example, you withdraw $7,000 for yourself as a first-time homebuyer, then you take out another $5,000 to help your child buy a first home. On the second home, the 10% additional penalty would apply to $2,000 ($7,000 + $5,000 = $12,000; $12,000 – $10,000 = $2,000).
Tax Withholding for Distributions from a Tax-Deferred Account
You can choose not to have any income tax withheld from a distribution that is going to be used for the acquisition of a first home. Unless you choose no withholding, the withholding rate for this situation will be 10% of the distribution, but you can also ask the payer to withhold more. If you do not have enough tax withheld, you may have to make estimated tax payments and/or pay in at tax time. I recommend running the numbers from your prior return (or using an estimate for the current year) to see where you would stand.
Tax-Time Notes (Traditional IRA)
On the Form 1099-R that you receive from the payer, box 7 will likely have the number 1 in it: “Early distribution (except Roth), no known exception.” Do not panic. On the instructions for Form 1099-R, the payer is instructed to use Code 1, even if the distribution is used to purchase a first home. You will claim the exception later, on Form 5329. Your tax person should be able to help you. TurboTax will also walk you through it (it takes a few steps, so be patient before panicking).
Roth IRA Considerations
A distribution from a Roth IRA cannot qualify for penalty avoidance until after five years from the beginning of the first year for which a contribution was made to a Roth IRA set up for your benefit. For example, if the first contribution to your Roth IRA account was October 1, 2009, you could qualify for a penalty-free withdrawal starting January 1, 2014. Your first contribution was in 2009, so the five-year period starts from the beginning of that year (January 1, 2009). Fast forward five years and you get January 1, 2014. Therefore, the waiting period is somewhere between four and five years.
Additional Resources
- 26 U.S.C. § 72 (IRC §72) – Annuities; certain proceeds of endowment and life insurance contracts – http://www.law.cornell.edu/uscode/text/26/72
- IRS Publication 590, Individual Retirement Arrangements (IRAs) – http://www.irs.gov/uac/Publication-590,-Individual-Retirement-Arrangements-(IRAs)
- IRS Publication 575, Pension and Annuity Income – http://www.irs.gov/uac/Publication-575,-Pension-and-Annuity-Income-2
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