The Roth Advantage Part 2: First Time Homebuyer

March 16, 2018

Dan Kresh FPQP™


There are ways for first time homebuyers to access some funds from retirement accounts without "penalty". Though you may be able to avoid an early withdrawal penalty, you will be lowering the amount in your retirement account. You would likely be purchasing your first home many years before you plan to retire, depleting your account when it has the most time to grow. This is a complicated decision. It is important to understand the differences between how you could access funds early from Traditional or Roth IRAs.

A first-time homebuyer can access up to $10,000 from either a Roth or Traditional IRA to contribute towards a down payment[i]. Any funds taken out from a Traditional IRA, for any reason, including a first-time home purchase would be taxed as ordinary income. The tax deferred nature of the Traditional IRA is its biggest advantage, so using funds from a Traditional IRA to help fund a home purchase will forfeit some of that benefit while shrinking your nest egg.
With a Roth IRA, you can take out contributions at any time for any reason without a tax consequence since it's already after-tax dollars[ii]. The Roth IRA owner can also access up to $10,000 of profit for a first-time home purchase, and if you have had the Roth for more than 5 years that would be tax free.[iii] You should NEVER consider a retirement fund an emergency fund, however; the fact remains that there are less barriers and penalties to accessing funds from a Roth IRA early than from a Traditional IRA.

Tapping into your retirement account to buy a home should not be your first choice, but it's nice to know what options could be on the table. You have the best chance of growing your nest egg if you contribute the maximum into your IRA for as long as possible. Taking funds out of your retirement account before retirement age, with or without penalty and or tax, means you will have a smaller principal to hopefully compound over time. Your retirement money will serve you best in retirement and should be invested in a well-diversified portfolio for the long haul. Any investment involves the risk of loss of principal but the more diverse your investments and the longer your time horizon the better your chance is to mitigate that risk.

If your income is at or approaching limits for contributing to a Roth IRA part 3 of this series will discuss a potential way for you to contribute to a Roth IRA using Roth conversions. It's never too early to start thinking about retirement. The earlier you start the more time you have for growth. You work hard for your money, we work hard so your money can work for you.

[i] IRS
[ii]Roth IRA Withdrawl
[iii]IRA To Buy A House

A Roth IRA distribution is qualified if you've had the account for at least five years and/or the distribution is made after you've reached age 59½, because of your total and permanent disability, in the event of your death or for first-time homebuyer expenses. Distributions made prior to age 59 1/2 may be subject to a federal income tax penalty. If converting a traditional IRA to a Roth IRA, you will owe ordinary income taxes on any previously deducted traditional IRA contributions and on all earnings.

You should always consult a tax professional and though this piece contains some tax information it should not be considered tax advice.

I is for Inflation

https://www.treasurydirect.gov/

What are I Bonds?

Series I Bonds are issued by the U.S. Treasury and pay interest using a composite rate (composed of a fixed rate and an inflation-adjusted rate). The fixed part of the rate has been 0 for the last two years and .5% or lower for more than a decade! The inflation-adjustment is recalculated semiannually in November and May. The inflation-adjustment in November 2021 for bonds issued in the 6 months after that date was an all-time high of 7.12%!

Many experts expect the May reset to be a whopping 9.62%![i]

I Bonds earn interest monthly and the principal is adjusted semi-annually meaning your money will compound over time. The composite rate can NEVER go negative.[ii]

Though there are purchase limits per person per year you can also buy them as gifts.[iii]

What are the Tax Consequences?

Always consult a tax professional, this is not tax advice: below we have directly quoted some pertinent information from TreasuryDirect’swebsite

“The interest that your savings bonds earn is subject to

  • federal income tax, but not to state or local income tax
  • any federal estate, gift, and excise taxes as well as any state estate or inheritance taxes.”[iv]

“Are there tax benefits to using I bonds to finance education?

Yes. Under the Education Savings Bond Program, you might be able to completely or partially exclude savings bond interest from Federal income tax. This can occur when you pay qualified higher education expenses at an eligible institution or state tuition plan in the same calendar year you redeem eligible I bonds and EE bonds issued January 1990 and later. You aren't required to indicate that you intend to use the bonds for educational purposes when you buy them, but you must make sure the program's requirements are met; some apply when you buy the bond(s). See IRS Publication 970”[v]

 

What’s the “Catch”?

  • You’re limited to $10,000.00 per person per year (an additional $5,000.00 can be purchased in paper I Bonds using your tax refund.)
  • You must hold it for a minimum of 1 year, so they aren’t immediately liquid.
  • If you hold them between 1 and 5 years you will be penalized the last 3 months of interest.
  • There’s no way to hold it in a brokerage account, or IRA and there’s no secondary market, you can only redeem them from the treasury or at a bank. You can purchase them electronically at https://www.treasurydirect.gov/

What are the Takeaways?

Though you can’t buy that much at one time they’re currently an amazing safe alternative to Certificates of Deposit (CDs). Even though there would be interest penalties for redeeming them in less than 5 years, they blow away any CD rates we have recently seen. Since you can purchase them as gifts, it could be a way to help fund higher education or let some of your beneficiaries have the opportunity to enjoy some of their inheritance during your lifetime. Though no one knows for sure, inflation could be peaking, so buying them before the reset in May might be the best move, you would guarantee half of that 7.12% for the first 6 months and whatever the May reset is for the 6 months after that.

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