The Tax Impact of an IRA Withdrawal for a First-Time Homebuyer

Ordinarily if you withdraw money from an individual retirement arrangement plan before you are 59 1/2, you must pay a special penalty tax of 10 percent to the Internal Revenue Service. If you're a first-time homebuyer, however, you can take advantage of a special first-time homebuyer IRA withdrawal rule letting you take out as much as $10,000 from the account without a tax penalty. Whether this will save you money, including tax money, in the long run can depend on a number of factors.

How IRAs Work

A traditional IRA is an account that you can set up for yourself to save money for retirement. While you are working, you can contribute up to $6,000 per year to the accounts, or up to $7,000 per year if you are age 50 and up, and deduct that money from your federal taxable income. Those limits are effective as of the 2019 tax year, up from $5,500 and $6,500, respectively, for 2018.

If you want to open an IRA, many financial institutions, including banks, brokerages and credit unions, will be able to help. Within the IRA, you can invest in a wide variety of investments as long as they're supported by the institution where you have the account. These can include stocks, bonds and mutual funds.

Retirement Age IRA Withdrawals

Once you reach age 59 1/2, you are able to begin to withdraw funds from the account without a penalty, but you will have to pay tax at your then-current ordinary income tax rate on the money. Deferring taxes until retirement is often advantageous, since many people naturally pay a higher tax rate during their working years than their retirement years.

If you withdraw money from the account before that retirement age, you must pay tax on the money at your ordinary income rate and also pay a 10 percent penalty tax to the IRS. Certain exemptions apply that allow you to waive the penalty under special circumstances.

IRA Withdrawal for Homebuyers

One exception to the 10 percent penalty tax is for qualified first-time homebuyer distributions from an IRA. The law lets you withdraw up to $10,000 from an IRA for costs used to acquire, build or rebuild a home for a first-time homebuyer, including yourself, your spouse, your child, your grandchild or your parent or other ancestor (such as grandparent or great-grandparent).

Naturally, if you are 59 1/2 or older, you can withdraw as much as you wish without a penalty, although you will owe tax.

Other IRA Rules for Homebuyers

The homebuyer needs to enter into a binding contract to buy the home within 120 days of withdrawal or start work on building or rebuilding it within that period. To qualify as a homebuyer, the person in question must not have had a financial interest in a main residence within two years prior to the home's acquisition. This means that it is technically possible to qualify as a first-time homebuyer more than once in your life.

Even if you make multiple such withdrawals to contribute to multiple qualifying people's houses over the course of your life, you can only claim a lifetime maximum of $10,000. Remember that you will still owe income tax on what you withdraw from the IRA. You simply won't owe the penalty.

Other IRA Withdrawal Exceptions

There are other circumstances beside buying a first home in which you can withdraw from an IRA without paying a tax penalty, though you may still owe tax on your earnings if you have enough income that you're required to pay federal income tax.

If you become permanently and totally disabled, you may withdraw money from your IRA without a penalty. You are also able to do so to pay for health insurance for yourself or your family if you become unemployed or to pay for health care costs in excess of 7.5 percent of your federal adjusted gross income for a year.

You can withdraw money from your IRA without penalty in certain situations if you're called up to active military service from the reserves. There's also an exception letting you do so to pay certain qualifying higher education expenses for your family.

Understanding Roth IRAs

A Roth IRA works differently from a traditional IRA. With a Roth IRA, you put money into the account from your earnings but pay tax on it as usual in the year you earn it and contribute it to the account.

When you withdraw money from the account after age 59 1/2, however, you don't owe any further tax. This allows your money to appreciate tax-free, which can be advantageous if you anticipate having a high rate of return on your investments or being in a high tax bracket when you retire and wish to access your money. You also must have had money in the Roth IRA for at least five years from the first tax year in which you contributed to the Roth IRA.

Roth IRAs and Penalties

Otherwise, if that holding period hasn't ended or if you're under 59 1/2, you will pay the 10 percent tax penalty and income tax on your Roth IRA earnings. The money you contributed to the IRA can be withdrawn tax-free, however.

You can also withdraw earnings tax-free from a Roth IRA after the five-year holding period but before you are age 59 1/2 if you qualify for one of the exceptions that lets you withdraw money early from a traditional IRA. That includes the first-time homebuyer rule, so you can withdraw up to $10,000 of earnings from a Roth IRA to buy a first home, if you have had the account and put money into it for the five-year period. Just keep in mind that with a Roth IRA, as a first-time homebuyer with less than five years of history on the account, you will still be subject to taxes and penalties.

Other Retirement Accounts and Rollovers

Employer-sponsored retirement accounts, such as 401(k) and 403(b) accounts, have different rules about when you can access your funds without paying a tax penalty. Specifically, these accounts generally don't allow you to make a $10,000 withdrawal for first-time homebuyer expenses the way IRAs do.

Once you leave an employer, you are usually able to roll over your funds to a traditional IRA, which often will give you access to more situations in which you can access the money early without penalty. It can also give you access to additional investment opportunities depending on the institutions where you have the account.

Making the Transfer

You generally will want to have one financial institution transfer the account or the funds to another without you taking possession of the money in order to simplify the transaction.

If you do take possession of the funds, you may have some money withheld for tax purposes until you file your return, and you will have to make this money up out of your other savings, or be treated as making an early withdrawal. You also must generally deposit the money in an IRA or another new retirement account within 60 days, or you'll be treated as having withdrawn it.

It's also possible to roll money over from one IRA to another, though if you take possession of the funds yourself, such as by receiving a check or electronic transfer, you only have the 60-day window to place the money in a new IRA. You generally are only able to roll money in or out of a particular IRA once within a one-year period.