How to Tap an IRA for a Home Purchase

You can withdraw up to $10,000 penalty-free to buy or build a first home, but make sure you know the rules.

I am going to buy my first house this month and will withdraw some money from my IRA to make the down payment. I'm not 59½, but I understand that I can avoid the early-withdrawal penalty because the money will be used to buy my first home. What is the rule about using IRA money for a home purchase, and what proof do I need to provide at tax time to show that the withdrawal was for that reason?

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If you have a traditional IRA, you normally would have to pay a 10% penalty on any distribution before you turn 59½ (except to the extent that any of the withdrawal could be attributed to nondeductible contributions). However, you can withdraw up to $10,000 penalty-free over your lifetime to buy or build a first home for yourself, your spouse, your kids, your grandchildren or even your parents. If you're married, your spouse can also withdraw up to $10,000 from his or her IRA penalty-free toward the purchase. The withdrawal will still be taxed in your top tax bracket.

To qualify for the exception, the money must be used to buy or build the home within 120 days of the withdrawal. The definition of "first-time homebuyer" is quite broad: It means a person who hasn't owned a home for the past two years.

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The rules are different for Roth IRAs. You can draw from your Roth IRA contributions at any age for any reason without paying any taxes or penalties. So, if you are tapping a Roth IRA and your withdrawal does not exceed the total of your contributions over the years, you don't need the exception. The money is simply tax- and penalty-free.

If you're dipping into Roth earnings before age 59½, though, you need the exception to protect you from the 10% penalty on up to $10,000. Whether that money will be taxed depends on how long you've had the Roth. If the account passes the five-year test (five calendar years have passed since the start of the year for which the first contribution was made), the earnings are tax-free, too. If it doesn't pass the five-year test, the earnings are taxable even though the penalty is waived. Similar rules apply if you convert a traditional IRA to a Roth. For more information about IRA distribution rules, see IRS Publication 590, Individual Retirement Arrangements.

You don't need to provide proof to the IRA administrator that you're using the money for a home purchase, according to Vanguard, but you do need to file IRS Form 5329 with your tax return for the year of the withdrawal. See the Instructions for Form 5329 for more information. If you're withdrawing the money from a Roth IRA, you also need to complete IRS Form 8606 to show how much of the distribution came from contributions, how much was from conversions made more than five years ago, how much from conversions made fewer than five years ago, and how much from earnings. If you withdraw after-tax money from a traditional IRA, you'll also need to file Form 8606 to show the amount of after-tax money distributed, which will affect your tax basis in the future. See the Instructions for Form 8606 for more information about the calculation.

Kimberly Lankford
Contributing Editor, Kiplinger's Personal Finance

As the "Ask Kim" columnist for Kiplinger's Personal Finance, Lankford receives hundreds of personal finance questions from readers every month. She is the author of Rescue Your Financial Life (McGraw-Hill, 2003), The Insurance Maze: How You Can Save Money on Insurance -- and Still Get the Coverage You Need (Kaplan, 2006), Kiplinger's Ask Kim for Money Smart Solutions (Kaplan, 2007) and The Kiplinger/BBB Personal Finance Guide for Military Families. She is frequently featured as a financial expert on television and radio, including NBC's Today Show, CNN, CNBC and National Public Radio.