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Should I Add More to My IRA to Save for My Downpayment?

By Motley Fool Staff – Apr 7, 2018 at 3:57PM

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It’s legal to withdraw up to $10,000 from the retirement account to help buy your first home. But is it actually a good idea to use an IRA that way?

March 27 brings us the Motley Fool Answers podcast's monthly mailbag show, which Alison Southwick and Robert Brokamp dedicate to providing their best advice and insights in response to listener questions.

Our podcasting duet learned something last month: Having Ross Anderson, certified financial planner from Motley Fool Wealth Management -- a sister company of The Motley Fool -- along for the ride makes it so much easier.

In this segment, they cover a seldom-used benefit of IRA accounts -- you can take money out of them penalty-free to use for the downpayment on your first home. Now, the Fool wouldn't recommend pillaging the funds you had set aside for your golden years that way, but there's a solution that lets you take advantage of this benefit without hurting yourself down the road.

A full transcript follows the video.

This video was recorded on March 27, 2018.

Alison Southwick: The next question comes to us from Tyler. Tyler writes: I'm 27 years old and saving for a down payment for a house. The goal is to have at least enough for a 20% down payment when I'm 35 or so. Since I have a medium-term time horizon for this goal, I'm currently keeping my house fund in a taxable account invested in the Vanguard Wellington Fund in order to grow my savings better, faster, stronger than a boring savings account.

Supposedly you can withdraw up to $10,000 from an IRA to help purchase a first home. I'm already contributing to my retirement, but does it make sense to increase my contributions to my IRA account in order to take advantage of the tax break with the thought that I would use some of the money for a down payment later?

Robert Brokamp: Yes. By the way, great job. You're 27 and doing that. That's awesome. [When you say that you are already contributing to your retirement], I'm going to assume that you are contributing enough, and someone your age should be contributing about 15% of your income and that includes the match. If you're contributing 10% to a 401(k) and your company is matching 5%, you're hitting that 15%. So, you're doing fine with your retirement.

First of all, you're asking, implicitly at least, whether the Vanguard Wellington is a good place to put that money, and I actually think that's a pretty good fund. It's a balanced fund that's 65% stocks and 35% bonds. It's finished in the last top 10% of its category over the last five, 10, and 15 years. Very low cost and gold-rated by Morningstar, so I think that's a great choice for money that you're going to need in the intermediate term. You're looking at like seven or eight years. I think that's great.

As you're pointing out, though, it is in a taxable account and according to Morningstar, you're losing about 1-2% of the return on that fund due to taxes. Should you instead put it in an IRA and use it for a house? I think it's worth considering, because you are right. There is the first-time home-purchase exception to take out money from an IRA to buy a house.

The actual taxes and penalties depends on the IRA. If it's a traditional IRA, it's $10,000. You take the money out. It's still taxable -- you get the tax-deferred growth along the way -- but it's still taxable. You don't pay the 10% penalty, but you do pay taxes when you take the money out. And by the way, that's a $10,000 limit per person, so if you're married, they can take out $10,000. Well-meaning relatives who want to help can also take out $10,000, but it's a lifetime limit, so if you've done it in the past, you can't do it again.

The Roth gives you a lot more flexibility, because when you take the money out for the Roth, the thing that comes out first are the contributions. Those are always tax and penalty-free. Then when you hit the earnings, you can take out that $10,000 without paying a penalty, and if the account has been open for five years, it's tax-free, as well.

So, I think it makes sense to do that for your situation, but I would choose the Roth IRA over the traditional if you can.

And by the way, the definition of a first-time home purchase for the IRS is kind of ridiculous. It just means that you haven't owned a house in the previous two years. If you owned a house three years ago -- if you owned five houses more than two or three years ago -- you're considered a first-time homebuyer by the IRS.

Alison Southwick has no position in any of the stocks mentioned. Robert Brokamp, CFP has no position in any of the stocks mentioned. Ross Anderson has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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