With so many people having most or even all of their savings in retirement plans, tapping them for the down payment on a home has become common. But of all the retirement plans you might use as a source of funds for the down payment, the Roth IRA comes up as the very best. It has built-in tax advantages that can make it a preferred source of down payment funds.
What is a Roth IRA?
A Roth IRA is an IRA with a twist. In most respects, it functions just like traditional IRA. For example, you can contribute up to $5,500 per year, or $6,500 per year if you are 50 older. You are also free to choose where you invest the money.
Typically, IRA investors put their money in some type of self-directed account, such as an investment brokerage account or mutual fund family. There the money accumulates on a tax-deferred basis until withdrawals are permitted beginning at age 59 ½. Withdrawals taken before that age are subject to a 10% early withdrawal penalty, as well as ordinary income tax.
But the primary difference between a Roth IRA in a traditional IRA has to do with taxes. While contributions to traditional IRAs are usually tax-deductible, contributions made to a Roth IRA are not tax-deductible.
The tax-advantaged shifts at retirement. Distributions to from a traditional IRA after age 59 ½ are subject to ordinary income tax. But distributions taken from a Roth IRA are tax-free if taken after age 59 ½, and as long as the plan has been in place for at least five years.
This tax-free retirement income feature is the reason why the Roth IRA has become so popular.
How to Use a Roth IRA for the Down Payment on a Home
In addition to the fact that a Roth IRA is an excellent source of tax-free retirement income, it’s also one of the best sources of cash for a down payment on a home.
Remember how we said that contributions made to a Roth IRA are not tax-deductible? That means that those same contributions can be withdrawn from your account – early – without creating an income tax liability for you.
The reason why that’s true is because of the priority that the IRS assigns to funds withdrawn from a Roth IRA.
According to IRS Ordering Rules for Distributions from a Roth IRA account, the first funds withdrawn from the plan will be your regular contributions. Since these contributions were made on an after-tax basis – which is how Roth IRA contributions work – the amount of the distribution will not be subject to income tax. Also, the distribution won’t be subject to the 10% early withdrawal penalty either.
That means that you can withdraw the full amount of your actual contributions from your Roth IRA without having to pay either income tax or the 10% early withdrawal penalty on the amount of the distribution. In that way, a Roth IRA can function similar to a checking or savings account.
It’s important to point out that any withdrawals from a Roth IRA that include earnings on your contributions will be subject to ordinary income tax. Also, you may also have to pay the 10% early withdrawal penalty, if you are withdrawing the funds before turning age 59 ½.
For example, let’s say you withdraw $10,000 from your Roth IRA, of which $8,000 represents your contributions, and $2,000 is earnings on those contributions. $2,000 of the withdrawal be subject to ordinary income tax and the early withdrawal penalty. But the $8,000 portion that is from your contributions will escape both.
But you might get a break on that front as well. The IRS also has a $10,000 exception for the purchase of a first home that applies to IRA accounts. That includes the Roth IRA.
Why a Roth IRA is a Better Down Payment Source than other Retirement Plans
Not all retirement plans are alike. With most, the tax cost of withdrawing funds from the plan will be prohibitively high.
For example, if you withdraw the funds from a traditional IRA, the full amount of the withdrawal will generally be subject to income tax. And unless you’re a first-time homebuyer, who can take advantage of the $10,000 exemption, you will also have to pay the 10% early withdrawal penalty.
401(k) plans are even more complicated. To start, many employers do not allow you to even take early withdrawals, even in the case of making a down payment on a home. But any withdrawals taken from the plan will be fully taxable, and subject to the 10% early withdrawal penalty.
401(k) plans do have the benefit of loan privileges in a lot of cases, but that will subject you to making repayments. That’s probably the last thing that you need when you’re taking on what is typically the higher monthly cost of purchasing a new home.
A distribution from a Roth IRA, however, is a clean source of funds for a down payment. There’s generally no tax to be paid or loan payments that need to be made.
A Roth IRA Can Also Be Used for Cash Reserves
Cash reserves are a financial cushion that mortgage lenders often require you to have. The basic idea is that you have sufficient liquid assets to cover an amount equal to anywhere from two months to six months of your new monthly house payment.
For example, if your new monthly house payment will be $1,500, and the lender requires you to have two months cash reserves, you will need to have $3,000 in liquid assets after closing.
A Roth IRA can serve this purpose. What’s more, while it satisfies the cash reserve requirement for the mortgage lender, the money in the account can accumulate investment income on a tax-deferred basis. That means that the account can help you buy a home even if you never have to take withdrawals for the down payment.
And even if the lender does not require you to have cash reserves, a Roth IRA can serve as something like an emergency fund. For all of the same reasons that you can withdraw your contributions for a down payment, you can also withdraw them to cover an unexpected emergency.
The bottom line: saving money in a Roth IRA can be an excellent way to also save money for the down payment on a home.