The rules on taking an IRA distribution tax-free for first-time home purchase

Dear Tax Talk,
I have saved up a bit of a nest egg in preparation for a first-home purchase sometime over the next 9 to 18 months. In preparing my taxes it was brought to my attention that I could get a lot more back by maxing out an IRA contribution — $5,500.

I’d like to open an IRA, load it up with $5.5K, and then max out next year’s taxes to get the IRA total to $11,000 in post-tax dollars out of that nest egg. Then 9 to 18 months from now, I would take $10,000 of that back via the penalty-free first-home purchase distribution and leave $1,000 post-tax in the account and whatever interest accumulates. The distribution itself, being post-tax, should not be income re-taxable either, right?

So my question is, am I able to funnel this $10,000 through a traditional IRA and take 2 years of IRA contributions on my taxes to increase my returns and then pull that $10,000 out penalty- and double-income tax-free when it comes times to purchase the home?
— John

Dear John,
The simple answer to your rather complex question is no, you will not be able to take the $10,000 out of the IRA tax-free when you are ready to make your first-time home purchase. The reason is because you are not dealing with “post-tax dollars” once you take the tax deduction on your income tax return to, as you put it “get a lot more back.” As you can see, your tax refund increases because of the tax deduction for the IRA contribution.

Congratulations to you for doing some research on this topic! I can see you really want to consider every angle in accomplishing your goal of homeownership. It seems to me that you may have confused 2 distinct tax concepts; the taxability of the distribution and the 10% additional tax that is owed on distributions taken before age 59 1/2.

So let’s start from the top:

• First of all, if you make a tax-deductible contribution to a traditional individual retirement account, or IRA, you will be taxed later on, when you take out distributions. One of the benefits of these accounts is that the account grows “tax-free” until the funds are distributed.
• Second of all, if you take distributions from the account before age 59 1/2, not only do you pay income tax on the distribution, but you must pay an additional 10% tax, unless you meet one of the exceptions for early withdrawals. By meeting the exception, it only means you are not subject to the “additional 10% tax.” You still are subject to paying tax on the distribution.

There are quite a few exceptions to the 10% additional tax penalty. A few are listed below.

Source: IRS Publication 590-B, Distributions from Individual Retirement Arrangements

As you can see, you are correct: Distributions of up to $10,000 used to buy, build or rebuild a first home qualify as an exception to the additional 10% tax.

Thanks for the really great question and all the best to you in your future home.

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