Oblivious Investor

A reader writes in, asking:

“What do you think about using a Roth IRA for a home down payment?”

This is a topic that generates endless disagreement, in part because when somebody asks this question, they can actually be asking either of two completely separate questions:

• What do you think about taking money out of a Roth IRA, to use it as a down payment on a home?
• For money that is already intended to be used as a down payment on a home, what do you think about contributing it to a Roth IRA (as opposed to simply leaving it in a taxable account)?

Let’s tackle the first question first, then the second. But before directly addressing either of those questions, we need to talk about the actual rules: how are distributions from a Roth IRA treated, when used for a home down payment?

Tax Treatment of Roth IRA Distributions When Used for a Home Purchase

Money that you contribute to a Roth IRA can come back out of the account at any time, free from tax and penalty. (Note: this is only for amounts that were contributed directly to the Roth IRA. For amounts that were contributed to a traditional IRA, then moved to a Roth IRA as a conversion, see this article.)

In addition, a distribution of earnings is free from the 10% penalty if it is a “qualified first-time homebuyer distribution.” And if you have satisfied the 5-year rule, the distribution will be free from regular income tax as well.

For a distribution to be a qualified first-time homebuyer distribution:

• It must be used within 120 days of the distribution…
• to pay “qualified acquisition costs”…
• on a “principal residence”…
• for a “first-time homebuyer.”
• And the homebuyer in question must be yourself, your spouse, one of your (or your spouse’s) ancestors, or one of your (or your spouse’s) descendants.
• Also, qualified first-time homebuyer distributions are limited to $10,000 over your lifetime. (Though if you’re married, your spouse gets his/her own $10,000 limit.)

As far as definitions:

• “Qualified acquisition costs” means what you would expect: costs of acquiring, constructing, or reconstructing a residence. And it includes any usual or reasonable settlement, financing, or other closing costs.
• “Principal residence” also means what you would expect: your main home. If you have more than one home, the IRS takes a “facts and circumstances” approach to determining which one is your main home. (You can find more information in Treasury Regulation 1.121-1(b) if you’re interested.)
• A “first-time homebuyer” is anybody who had no present ownership interest in a principal residence during the 2-year period ending on the date of acquisition for the home in question. If you are married, your spouse must also meet this requirement in order for you to qualify.

Using Money from a Roth IRA for a Home Down Payment

The decision of whether to buy a home obviously has many factors involved, many of which are not financial at all. Let’s assume that that decision has already been made and that you do intend to buy a home, so the question remaining is simply whether you should use money from a Roth IRA for the down payment.

When it comes to using assets for a home down payment, the general order of preference is as follows:

• Best to use taxable money (i.e., assets that are not in a retirement account at all — just regular checking/savings accounts and taxable brokerage accounts),
• Next-best to use “qualified first-time homebuyer distributions” from a Roth IRA,
• Next-best to use distributions of contributions from a Roth IRA — or distributions of converted amounts if those distributions would not be subject to the 10% penalty (e.g., because the conversion has satisfied its 5-year period or because the conversion was not taxable),
• Next-best to use other distributions (e.g., distributions of earnings) from a Roth IRA, distributions from a traditional IRA, or distributions from an employer-sponsored plan such as a 401(k) or Roth 401(k).

So the question then is: how much taxable money is there? If you have sufficient money in taxable accounts that you can cover the down payment that you want to make (while still having an emergency fund), then it’s an easy decision: don’t take money out of your Roth IRA for the down payment. Use the taxable assets instead.

If, on the other hand, you do not have sufficient assets in taxable accounts to fund the down payment, then the question is essentially: should you use Roth IRA money or delay the home purchase? On the financial side, whether waiting would pay off depends on:

• Whether another home comes available for sale that meets your criteria and which is approximately as affordable.
• What rate of return you earn on the assets that stay invested in the Roth IRA while you wait to build up your savings.
• Whether interest rates move upward or downward (because you will be getting a mortgage in the future, at those future interest rates, rather than at today’s rates).

And again, there are of course an assortment of non-financial factors that could, quite reasonably, affect your decision as to whether to wait or go ahead and buy the home in question now.

Contributing to a Roth IRA to Save for a Down Payment

A separate but related scenario is the case of somebody who plans to buy a home in the not-so-distant future, and they want to know whether it makes sense to put money into a Roth IRA when that money is likely to be used for a down payment. In other words, the question is basically “make Roth IRA contributions or do not make Roth IRA contributions.”

And the answer here is generally to go ahead and make the contributions, even if the money in question is intended to be used for a home down payment rather than retirement. There are a few reasons for this:

1. There’s not much of a downside from a tax perspective, given the way that distributions are treated when used for a first-time home purchase.
2. Making Roth IRA contributions may allow you to qualify for the retirement savings contribution credit.
3. And perhaps most importantly, if you later change your mind about the home purchase (or decide to delay it for other reasons), you will not have missed out on your Roth contributions for the year(s) in question.

There are two related points to note here.

First, if the money in question is intended to be used in the relatively near-term future, it should of course be invested conservatively.

Second, this general concept does not apply to Roth 401(k) contributions. If you have money that you intend to use in the near future for a home down payment, do not contribute it to a 401(k) — even a Roth 401(k). In some cases you won’t be able to get money out of a 401(k) at all until you have left the employer in question. And the special tax treatment (discussed above) that sometimes applies to distributions from an IRA when used for a home purchase does not apply to distributions from a 401(k) (whether Roth or not).