09/19/11: Tapping Your Retirement to Help Kids
By Benny L. Kass
Q: My wife and I want to buy a condominium now, especially since interest rates are so low. We need approximately $40,000 for the earnest money deposit, which is ten percent of the purchase price. My parents are prepared to lend us this money, but they will have to take it out of their Individual Retirement Account. Mom is 54 and Dad is 56. Can they do this?
A: Yes, with a large number of restrictions. The general rule is that if you have not reached the age of 59 ½, you must pay a ten percent penalty on any distribution from your IRA. This is in addition to the regular income tax you have to pay on that amount. This is referred to as "early distributions".
However, there are a number of exceptions, such as you are disabled, you have unreimbursed medical expenses that are more than 7.5 percent of your adjusted gross income, or the distribution is used to buy, build or rebuild a first home.
Let's look at this last exception carefully. First, the buyers must be "first-time" homebuyers. According to the IRS, you cannot have a "present interest in a main home during the 2-year period ending on the date of acquisition of the home which the distribution is being used to buy, build or rebuild." Since your son is married, his wife must also meet this no-ownership requirement. And the home to be purchased cannot be for investment purposes; it must be the principal home - which the IRS calls "the main home".
When is the "date of acquisition"? It is either the date of which you enter into a legally binding real estate contract to buy the property or the date on which the building (or rebuilding) begins.
You can use your parent's money for the deposit on the contract, or for any usual and reasonable settlement, financing or other closing costs. However, any moneys your parents take out above $10,000 will be taxed twice - first as ordinary income and second with the 10 percent penalty.
There are more restrictions: the moneys must be used by you no more than 120 days after the funds are withdrawn from the IRA. Your parents can agree to lend you these funds at any time, but once the funds are withdrawn, you must sign that sales contract and use the funds within the 120-day time limit.
And if you have brothers or sisters, they should understand that once your parents have used up the $10,000, any additional funds withdrawn from the IRA will generate the 10 percent tax. This is a lifetime cap. However, if both of your parents have separate IRAs, they can each give you up to $10,000 without having the pay the penalty. They will, however, have to pay ordinary income tax on these withdrawals.
What if your parents have a ROTH IRA? If that IRA has been in existence
for at least five years, and meets the requirements spelled out above for regular IRAs, there will be no 10 percent penalty and no income tax due on the first $10,000. Above that, there is a complicated "Ordering Rules", and you should consult your own pension plan trustee or advisor for specifics.
This discussion involved parents assisting their children. But the law is not limited exclusively to parents. According to the IRS, to qualify for treatment as a first-time homebuyer distribution, the funds can be used to pay the costs for a main home for any of the following: "yourself, your spouse, your or your spouse's child, your or your spouse's grandchild, your or your spouse's parents or other ancestor."
For additional information, the IRS has Publication 590, "Individual Retirement Arrangements (IRAs)", available on the web at IRS.gov/publications.
But before you pursue the IRA route, you should discuss this with your mortgage lender. In today's economy, even though interest rates are at an all-time low, it is very difficult to get loan approval. Your lender may want your parents to gift you the deposit moneys, instead of lending it to you. Your lender may also want to make sure that some of your own money is being used for the purchase.
According to Craig Strent, CEO of Apex Home Loans in Rockville, Maryland, "at 90% with none of the buyer's own money into the transaction, FHA would be the best option for the kids. If they were getting an 80 percent loan to value, with all funds gifted, they could go conventional."
"It's important for the kids to document where the earnest money deposit came from," Strent added. "The parents will have to show a copy of their bank statement along with proof of the funds leaving their account and going into the buyer's account. Many people find this intrusive, but it is a required step to verify that the funds were indeed a gift, and not some internal arrangement to circumvent the underwriting requirements."