Here's What Happens When You Take an IRA Withdrawal to Buy a Home

The money in your IRA account is supposed to serve an important purpose -- to give you funds to live on once you stop working. The IRS wants to encourage savers to put money into their IRAs. That's why you get the benefit of tax-free contributions to an IRA, and tax-deferred investment gains (meaning, you don't pay taxes on gains year after year, but rather, when you take withdrawals).

Because of these tax breaks, the IRS doesn't take kindly to non-retirement withdrawals from an IRA. And so generally, tapping that account prior to age 59 1/2 will result in a 10% early withdrawal penalty.

There is, however, an exception for first-time home buyers. If you fall into this category, you can remove up to $10,000 from your IRA if you're putting that money toward a first-time home. And if you're buying a home jointly with a spouse or partner, they, too, can tap their IRA to the tune of $10,000 penalty-free. So all told, it's conceivable that $20,000 of your home down payment might come from IRA funds without any penalties involved.

But just because you're allowed to take a penalty-free IRA withdrawal to buy a home doesn't mean that's the best idea. While accessing that money may get you closer to homeownership sooner, it could leave you short on funds once retirement rolls around.

The danger of raiding an IRA for non-retirement purposes

The money in your IRA doesn't just sit there in cash. Rather, it should be invested so that, ideally, it grows into a larger sum over time.

When you remove funds from an IRA, you leave yourself with that much less money in retirement. But also, you lose out on gains associated with that money.

So, let's say you take a $10,000 IRA withdrawal at age 35 to buy a home. You might think, "Oh well, guess I'll have to make it through retirement with $10,000 less." But actually, your decision might have greater consequences.

Let's imagine your IRA is invested in a manner that generates a 10% average annual return. That's the average yearly return the stock market has delivered over the past 50 years (before inflation), as measured by the performance of the S&P 500.

If you end up retiring at age 65, taking a $10,000 withdrawal from your IRA at age 35 could end up costing you about $175,000 when you factor in lost investment gains. That's a much bigger deal than getting to retirement age with $10,000 less to your name.

It's best to leave your IRA alone

The purpose of an IRA is to save for retirement. Tempting as it may be to access some of those funds for a home purchase, your down payment is something you're better off saving for separately.

You may need to delay homeownership a bit in the absence of raiding your IRA. But you might end up very thankful for that decision once retirement rolls around and your nest egg is looking nice and robust because you left it alone.