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Should You Use a Roth IRA to Buy a House? Yes, If...

In today’s edition of why you shouldn’t ask tax questions on Reddit, we look at why Roth IRAs are NOT just for retirement and can actually be a smart way to buy a house.

Roth IRA Refresher

A Roth IRA is a type of IRA that lets you grow your money tax-free. Unlike a traditional IRA, you don’t get a tax deduction when you contribute to a Roth IRA (but you might qualify for the Saver’s Credit).

With a Roth IRA, you put in after-tax money. Since you’ve already paid taxes on the money you put in, you don’t have to pay taxes on the money you take out in retirement. But wait, there’s more…

When you contribute to a Roth IRA, you can take out your contributions at any time without taxes or penalties. So let’s say you’ve put in $10,000 and you’ve doubled it to $20,000. You can take out that first $10,000 even if you haven’t hit retirement age yet.

Now if you want to take out your earnings above your initial contributions, you either have to

  • Have reached retirement age (currently 59.5)
  • Have a qualifying exception allowing a penalty-free early withdrawal
  • Pay income taxes on the earnings plus a 10% penalty

IRA Home Buying Exception

One of the early withdrawal exceptions for IRAs is for first-time homebuyers. First-time homebuyers can include actual first-time buyers as well as people who haven’t owned for at least the last two years.

As long as you’ve had your Roth IRA open for at least five years, you can generally take out an extra $10,000 tax-free and penalty-free. That’s on top of your Roth IRA contributions.

In other words, if you buy a home using Roth IRA money, you can take out all of your contributions plus an additional $10,000 without taxes or penalties.

There are two things that can mess this up.

  • You also withdrew money from your Traditional IRA: The $10,000 is from either a Roth IRA or a Traditional IRA or split between the two. It’s not $10,000 from each.
  • You converted a Traditional IRA, SEP IRA, or 401(k) to your Roth IRA: That can start a new five-year waiting period but only on the money you’ve converted.

For more info, see IRS Publication 590-B.

But should you use your Roth IRA to buy a house?

Yes, using a Roth IRA to save for your down payment can be a good idea. That’s why the IRS has these rules. When people say you shouldn’t there are three reasons (one legit):

  • They don’t know you can access Roth money without taxes or penalties
  • They think you shouldn’t invest money that you’ll need to buy a home in the near future
  • You can only put so much money into a Roth IRA each year

We’ve already talked about taxes and penalties, so let’s discuss investing.

You don’t have to put your Roth IRA money into stocks and bonds. There are banks that have Roth IRA savings accounts (Ally Bank is popular). Most of the major brokers have options to put your Roth IRA money into money market funds, CDs, or short-term treasuries.

Using a Roth IRA savings account is exactly the same as using a regular savings account except it follows the Roth IRA tax rules. If your current Roth IRA broker doesn’t have suitable options for your down payment savings, you can transfer your Roth IRA to another broker that does without taxes or penalties.

Now the annual Roth IRA contribution limits are something to think about. When you take money out of your Roth IRA to buy a house, you can’t put that money back in later and will end up with less in your Roth IRA.

If you’re able to both max out your Roth IRA and save for a down payment in a regular savings account, it’s usually better to do that so you can use your Roth IRA to grow your retirement savings.

If you need to slow down on your retirement savings to build up a down payment, save for your down payment in a Roth IRA. If you need the money to buy a house, you can take it out. If you don’t need all of that money, you have more money inside of your Roth IRA that you can invest for retirement.