All About IRAs

For First-Time Home Buyers

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By Roy Lewis

It's not often that you can take money from your traditional IRA or from your earnings in a Roth IRA before age 59 1/2 and avoid the dreaded 10% early withdrawal penalty. But, surprisingly enough, this is one of the tax benefits enacted as part of the 1997 Taxpayer Relief Act to help people become homeowners.

Now the law allows individuals to receive distributions from their traditional IRAs to pay up to $10,000 of first-time homebuyer expenses without incurring the 10% early withdrawal penalty that usually applies to withdrawals from a traditional IRA before age 59 1/2. But, even though the penalty is waived, you will still be required to pay taxes (as applicable) on the traditional IRA withdrawal itself.

The rules for taking a distribution from a Roth IRA to finance a first-time home purchase are slightly different than those for a traditional IRA. Remember that a withdrawal taken from a Roth IRA for the purchase of a first home is considered a qualified distribution after the account has been open for five tax-years. As such, any distribution taken from a Roth for that purpose and under those conditions will be both income tax- and penalty-free.

But also remember that under the Roth distribution ordering rules, the first money out will be annual contribution money, which is never taxed or penalized. Next out would be conversion money, and that also would not be taxed or penalized provided it has been in the Roth for five tax-years.  And last out would be earnings. Therefore, because of these distribution rules, that means the only money taken from a Roth IRA that might pose a problem would be either earnings or conversion money that has been in the Roth for less than five tax-years.

What happens if you take earnings or conversion money before the necessary five tax-years have run? Well, in the case of earnings, you still meet the exception to avoid the early withdrawal penalty, but you don't meet the criteria for a tax-free withdrawal from a Roth IRA. Accordingly, just as you would for a withdrawal from a traditional IRA, you must pay an ordinary income tax on the distribution.

When it comes to taking a withdrawal of conversion money early, you won't owe income tax because you already paid that during the original conversion.  Ordinarily, though, those under age 59 � would owe the 10% early withdrawal penalty for taking the money before five tax-years had passed since the conversion.  But a distribution for a first home purchase is an authorized exception to the early withdrawal penalty on IRA distributions. Therefore, conversion money, even when taken early, may be used for this purpose free of penalty.

In an odd twist of government logic (is there really such a thing?), you should know that a "first-time homebuyer" doesn't really have to be a first-time homebuyer. That's because the law defines "first-time homebuyer" as someone who has not owned a home for two years. So in addition to benefiting "first-time" homebuyers, the law also helps "not-recent" homebuyers. And, in yet another twist of government logic, you can take advantage of the provision even if you are not the first-time homebuyer, since the first-time homebuyer can be the traditional or Roth IRA owner, his or her spouse, or any of their children, grandchildren, or ancestors. So maybe this provision should really be called, "Penalty-Free Withdrawal for Not-So-Recent Homebuyers and/or Relatives of an IRA Owner." You be the judge.

Anyway, the $10,000 limit is a lifetime limitation on the amount of withdrawals in total that can be pulled out of all your traditional or Roth IRAs penalty free under the first-time homebuyer provision. Don't think that you'll get this relief each and every time you want to buy another home or each and every time you use a different IRA to make such a withdrawal. Once you use up your $10,000, you're done. And while the law isn't clear, it seems permissible that, for example, a husband and wife helping one of their children scrape together a down payment could each withdraw up to $10,000 from their respective traditional or Roth IRAs without incurring any penalty for early withdrawal.

Also note that any IRA funds distributed to you must be used to pay qualified acquisition costs before the close of the 120th day after the day you received the distribution -- so this isn't a completely "open-ended" deal. You need to plan your purchase and your distribution carefully. Qualified acquisition costs include the costs of buying, building, or rebuilding a home and any usual or reasonable settlement, financing, or other closing costs. So, the distribution must be related to the purchase of the property and can't be used for other home-related expenses such as furnishings or general home repairs or maintenance.

Remember that a loan repayment isn't a "qualified acquisition expense." For example, say you purchased a home three months ago and just became aware of the exception for a penalty-free IRA distribution. Could you take the $10,000 now and use it to pay off a portion of your mortgage? Well... you certainly could, but because this loan repayment is not deemed a "qualified acquisition expense" your $10,000 distribution would certainly be subject to the early distribution penalty. So, if you're interested in the penalty savings, you'll have to make sure that you plan ahead... and not behind.

And finally, this benefit is only available for traditional or Roth IRAs -- not for 401(k) or 403(b) accounts or any other type of retirement account.

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