A Roth IRA could help you buy a home. Here's what to know

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For some would-be homeowners, coming up with the cash to buy a house can be tricky.

Depending on your situation, a Roth individual retirement account could help.

In a nutshell, up to $10,000 in Roth IRA earnings can be withdrawn — free of both taxes and penalty — for a home purchase if you meet certain requirements. That's in addition to being allowed to withdraw your direct contributions at any time, because you already paid taxes on that money.

As home prices continue rising amid a tight housing market, the amount of cash needed to purchase one is climbing, as well.

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While it's possible to buy a house with less than 20% down — the average is 12% overall and 6% for first-time buyers — going that route also might mean paying private mortgage insurance, or PMI, until your equity is at least 20% of the home's value. PMI can run $30 to $70 monthly for each $100,000 borrowed, according to Freddie Mac.

For a $250,000 house, a 6% down payment would be $15,000. At 20%, it would be $50,000. Those amounts don't include other costs related to the purchase, such as transfer taxes or points, which generally lower the interest rate on the loan. (One point is equal to 1% of the mortgage). 

At the same time, the cost of borrowing is relatively cheap due to low interest rates. The average rate on a conventional 30-year mortgage is about 3%, according to Bankrate.com.

Nevertheless, using Roth IRA money to buy a house is not a strategy that makes sense for everyone. Here's what to consider.

Basic Roth rules

Roth IRA contributions are made after-tax. This means you can withdraw that money at any time without penalty. The 2021 contribution limit is $6,000 ($7,000 for individuals age 50 or older).

However, to make contributions at all, your modified adjusted gross income can't be above a set amount. To contribute the maximum, the income cap is $125,000 if your tax filing status is single, and $198,000 for married couples who file jointly. Above those income amounts, the contribution limit is reduced until completely phasing out at income of $140,000 for single tax filers and $208,000 for joint filers.

While those contributions are yours whenever you want them, the same can't be said for any growth in the account. Unless you meet an exclusion — such as reaching age 59½ and having owned a Roth IRA for at least five years — withdrawing earnings will generate taxes and a 10% penalty.

For qualified first-time home purchases, that 10% penalty is waived. However, to avoid taxes on the earnings, you must have held the Roth IRA for at least five years (with some exceptions related to the timing of contributions).

For Roth conversions — that is, money moved to a Roth IRA from another retirement account — you generally must sit on it for five years if you're under age 59½ to avoid the 10% penalty on any withdrawals (unless you meet the first-time-home-buyer exclusion).

The nitty gritty

The exclusion is for first-time home buyers or people who haven't owned a house as a primary residence in at least two years. The buyer can be you, your spouse or one of your family members.

The withdrawal also must be used within 120 days of the distribution and be used to pay for expenses related directly to the home purchase, such as a down payment or other closing costs. And, the $10,000 earnings exclusion is a lifetime limit.

As long as we can meet the five-year rule, they can use all contributions plus up to $10,000 of gain, free of tax and penalty.

Daniel Galli

Principal of Daniel J. Galli & Associates

Be aware that traditional IRAs also come with the penalty-free exclusion for qualified home purchases. However, the $10,000 limit is applied to the entire withdrawal, said certified financial planner and CPA Jeffrey Levine, chief planning officer Buckingham Wealth Partners in Long Island, New York. And, you'd generally pay taxes on the money.

Setting up a Roth IRA for a home purchase

The flexibility of a Roth might make it a good place to save up to buy a house down the road, some advisors say. 

"We've long suggested that young people use a Roth IRA to save the considerable amount needed for a first-time home purchase," said CFP Daniel Galli, principal of Daniel J. Galli & Associates in Norwell, Massachusetts.

"As long as we can meet the five-year rule, they can use all contributions plus up to $10,000 of gain, free of tax and penalty," Galli said. 

However, he said that he has recommended this strategy to young workers who also are saving for retirement through a 401(k) plan at work.

Additionally, Galli said, there can be risk involved, depending on how aggressively you invest the money in the Roth IRA.

"This strategy requires some market risk in order to enjoy some gains, but the rewards can balance that," Galli said.

If you do go this route, the amount of risk you should take on in your portfolio depends partly on how long until you need the money, said Levine at Buckingham Wealth Partners. If you're planning for something 10 years out, he said, you could start out aggressively invested in stocks and gradually reduce your exposure.

"You might want to make it more conservative over time," Levine said.

Using existing Roth money

If you already have money in a Roth IRA and are now eyeing it as a way to fund a home purchase, be aware that many financial advisors caution against using that money if it was earmarked for retirement.

"These accounts are designed to help people accumulate as much money as possible for retirement," said CFP Shon Anderson, president of Anderson Financial Strategies in Dayton, Ohio.

"You can obtain a loan for a home, car, business venture, college tuition ... but no one will ever receive a loan to retire," Anderson said.

However, depending on your situation — i.e., how much you'd be withdrawing, whether you have sufficient retirement savings elsewhere, if you can otherwise afford the house payments and costs of homeownership — using the Roth money for a house might make sense.

"If the person is contributing to a 401(k), getting a decent match, they're on a good track for retirement and the Roth is just a nice addition, I might consider it," Galli said.

"But if their only retirement savings is the Roth and they're, say, in their 40s, I probably wouldn't," he said.

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