Can I use my IRA to buy a home?

Even though home prices have recovered somewhat over the past few years, it might still be a good time to buy a house. Mortgage interest rates have remained at historic lows. If you are under age 59½ you will pay a 10 percent penalty on the taxable portion of withdrawals from a traditional IRA unless you meet one of the penalty exceptions.

One of those exceptions is a withdrawal of up to $10,000 to buy, build or rebuild a “first home.” This same penalty and penalty exception applies to withdrawals of earnings from a Roth IRA, and the $10,000 is a cumulative lifetime limit that applies to all your IRA accounts. You can’t withdraw $10,000 penalty-free from your traditional IRA and another $10,000 penalty-free from your Roth IRA. For purposes of this penalty, the IRS considers you as a first-time homebuyer if you have not owned a home for at least two years. Any money you withdraw from a traditional IRA is taxed except for your “basis” in the IRA. Your basis is the amount that you contributed that you could not deduct on your tax return when you made the IRA contribution. You keep track of your basis on IRS Form 8606. When you make a withdrawal, you prorate it to find the taxable and nontaxable amounts. For example, if you have $50,000 in your IRA with a $10,000 basis, 20 percent of your withdrawal is nontaxable. If you withdrew the entire $50,000 you would pay tax on $40,000 and if you were under 59½ you would also pay a 10 percent penalty on $40,000. If you used the money to buy a first home, you would pay taxes on $40,000 and a 10 percent penalty on $30,000.

The rules for taxing withdrawals from Roth IRAs are different. You won’t pay any tax or penalty on a qualified withdrawal, which is defined as a withdrawal after you meet a five-year holding period that starts on the first day of the first year during which you first made a Roth IRA contribution and you were either 59½ or older, or the distribution is due to death or disability, or the distribution is eligible for the first-time homeowner exception to the 10 percent penalty tax on early distributions.

Withdrawals from Roth IRAs are not prorated like they are for traditional IRAs. Withdrawals are considered to come first from contributions and then from earnings. No income tax or penalty applies until total withdrawals exceed total contributions (except in the case where the money was from an IRA conversion within the last five years). As an example, let’s assume you have contributed $20,000 to your Roth IRA and it has grown to $24,000. Since distributions are not taxed to the extent they represent a return of contributions, you can withdraw $20,000 tax and penalty free. If you withdrew the entire $24,000 you would owe income tax on $4,000 and a $400 penalty (no penalty if you used the money for a first-time home purchase).