Contributions into your Roth individual retirement account are after-tax contributions, and the earnings and distributions are tax-free — if you take them out at the right time.
The principal you put in — that is, the original money you contribute — is always yours to take out without penalty or waiting period because you’ve already paid tax on the funds. If you make $124,000 or less filing single or less than $196,000 filing jointly for tax year 2020 ($125,000 or $198,000, respectively, for 2021), the maximum you can contribute per year is $6,000.
In addition, you can withdraw up to $10,000 in earnings from the same account, free of taxes and penalties, for the purchase of your first home. This means that if you have a Roth IRA account that has been earning in the market for a couple of years, you can withdraw your principal plus an additional $10,000 in earnings — all tax free. If you draw on earnings in excess of $10,000, you will be penalized.
There are exceptions to this. An exclusion exists for those who are 59 ½ years of age or older and have owned a Roth IRA for at least five years. If you do not meet these requirements, your earnings will generate a 10% penalty and be taxed as income if you withdraw them.
So, if you are a first-time home buyer, you can draw the amount you contributed plus $10,000 in earnings without penalty, as long as you have held the account for at least five years. This applies if you have rolled your 401(k) or other retirement account into a Roth IRA.
There are some important consequences for using this strategy. Most first-time home buyers will be on the younger side. That means that a considerable amount of the money you have saved up for retirement will instead be diverted towards a home purchase.
If your plan is to start contributing to a Roth now and use this strategy for a down payment in the future, you have to assume market risks that cash savings don’t have. Also take into account the fact that the market averages around 6-8% per year, and often less. You need to consider if losing that rate of return is worth using this strategy versus saving cash for a home.
Financial advisors will typically recommend withdrawing money from your Roth IRA to buy home only if you’re already saving in a 401(k) as well. This hedges against the loss in your Roth while keeping you somewhat on track to earn the accrued interest you’ll lose if you take a Roth distribution.
If your risk tolerance aligns with the exposure, and you are simultaneously investing in your 401(k), then the strategy should be suitable. Often, though, people utilize this strategy because their friend or colleague tried it and not because it’s a suitable strategy for their own retirement goals. Staying on track for retirement is paramount, and simultaneously saving for a home purchase should involve the least amount of risk possible — or an adequate surplus of cash.
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