The Down Payment Hack You Might Not Know About

The Down Payment Hack You Might Not Know About

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Andrea Sielicki
Oct 5, 2018

(Image credit: living4media / J. Corrado Design)

The journey to becoming a homeowner can seem daunting. Saving a large sum for a down payment on your dream home isn't easy, especially considering today's rising home prices. Roth IRAs have first-time homebuyer benefits that could help you to save for that hefty down payment.

How it Works

Roth IRAs are retirement accounts where all contributions enter your account post-tax. You can remove all your contributions with zero penalty at any time. Investment earnings work a little differently. If you withdraw earnings from a Roth IRA before the age of 59 1/2, normally you would pay a 10 percent penalty. However, for certain exceptions–like buying a home–you can withdraw earnings penalty free.

The Rules

  • You must have had your account open for at least five years
  • You (and your spouse, if you are married) must be a first-time homebuyer
  • Earnings withdrawal limit without penalty is $10,000
  • Must use the funds for acquisition costs, meaning buying, building, or rebuilding a home. Also applicable to closing costs and financing payments.
  • Must use the money within 120 days, otherwise you may have to pay a 10 percent penalty

You can view the full rules listed by the IRS here.

The IRS has a pretty loose definition for first-time homebuyers. If you haven't bought a main residence home in the past two years, you qualify as a first-time homebuyer to the IRS. For married folks, your spouse must also qualify as a first-time buyer. Additionally, you can use the money to help a spouse, child, grandchild, parent, or other relative buy a home.

Investment Guidelines

Financial advisors generally do not recommend depleting retirement savings for home purchases. Using a Roth IRA might be a good approach if you have another retirement account, like a 401(k) through your employer. Depending how soon you want to post that "new homeowner" Insta will matter for your investment strategy. Serina Shyu, a CFP at Jon Baker Financial Group, suggests that if you're planning to purchase in two years or less, it's best to keep your down payment in cash. For a longer-term outlook, talk to a financial advisor about a risk-appropriate investment strategy that matches your timeframe.

When You Shouldn't Use a Roth to Fund a Down Payment

If your Roth IRA is your main or sole retirement account, you should probably not withdraw money for a home down payment. A good rule of thumb is to treat main retirement funds like money you don't own. That way, you won't be tempted to spend it.

The IRS limits annual Roth IRA contributions to $5,500 a year (or $6,500 if you're age 50 or older). If you make over $135,000 a year as a single person or $199,000 as a couple, the amount of money you can deposit in your Roth IRA account decreases. If you're a high earner, you might be better off saving for your down payment in a high-yield savings account instead.

Why Use a Roth instead of Traditional IRA?

Shyu recommends withdrawing housing funds from a Roth IRA over a traditional IRA if possible. She said of a traditional IRA, "Not only do you have to pay taxes on the money you take out, but you will have to pay additional income taxes due to the withdrawal being counted as income above and beyond salary on your tax return."

Because Roth contributions are already taxed, you can withdraw money without worrying about additional taxes.

Shyu, who actually withdrew from her own Roth IRA when she bought a house, said taxes influenced her decision to withdraw from her Roth for a down payment. "I knew the withdrawal would come out tax-free. With a traditional IRA, I would have incurred additional income taxes."

Documentation

If you plan to use Roth account funds to acquire a home, the IRS will expect some documentation on that year's tax return. Shyu recommends keeping all brokerage and bank statements that show any movement of the Roth IRA money. She said for her own payment, "I even kept the trade confirmation that generated the $10,000 needed. Depending on where you're at with taxes, you might not need to provide proof to the IRS, but it's always best to have it on hand just in case."

There's no one way to go about saving for a house. But the tax advantages and opportunity for investment earnings make a Roth IRA withdrawal worth at least looking into. Meet with a financial advisor if you think it could be a good fit for you.

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