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I am buying my first home and I am thinking about taking a distribution from my traditional IRA to pay a portion of the downpayment. This IRA is a rollover from my 403b plan with a previous employer. As I understand, I will not have to pay the 10% penalty, but I am a little confused by the language in the IRS publication. How do I prove that the early distribution was used for the downpayment? Is it enough to have the HUD-1 statement showing that the downpayment was more than the distribution amount?

Many thanks in advance,

Kirill
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I would document the whole trail of the funds. It would be something like IRA withdrawal ==> checking account ==> HUD-1.

So show the funds coming out of the IRA and into your checking account. And show the funds (or a larger number) going from your checking account to the settlement agent.

On your tax return, all you show is that the funds were used for a 1st time home purchase. Keep the documentation in your files in case the IRS ever asks for it.

Of course, there are lots of questions as to why you would want to sacrifice your future retirement when you may not need to. I'll just direct you over to the Buying and Selling a Home board for more info on financing your home purchase. In a nutshell, you have options besides breaking into your IRA piggybank.

--Peter
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ptheland,

Thanks for your advice. I feel comfortable with taking the money out because it's only a small portion of my retirement accounts. Preserving extra liquidity weighs more for me right now. I also like Roth IRAs more for their flexibility, so I can recover my base there without doing the conversion.

Kirill
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Thanks for your advice. I feel comfortable with taking the money out because it's only a small portion of my retirement accounts. Preserving extra liquidity weighs more for me right now. I also like Roth IRAs more for their flexibility, so I can recover my base there without doing the conversion.

You can NEVER recover your "base" once you withdraw it. You cannot make any contributions in excess of the annually allowed limit. There is no "payback" provision to return the removed funds to your IRA. Diverting retirement funds to other purposes is rarely a good idea since most people significantly underfund their retirement.

Ira

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You can NEVER recover your "base" once you withdraw it. You cannot make any contributions in excess of the annually allowed limit. There is no "payback" provision to return the removed funds to your IRA.

I can put more in a Roth than I intended to otherwise. In any case, what I intend to withdraw is only like 15% of the total.

Diverting retirement funds to other purposes is rarely a good idea since most people significantly underfund their retirement.

Unless you have a great 403b with generous matching. I know this goes against common wisdom, but for many people in their 30-s (like me) the retirement may be the simplest part of the total financial picture. With 13.5% of my salary going into a 403b (including matching), I tend to think that's enough. And also, with the long-term capital gains taxed at 5% you really don't pay that much for liquidity anyway.

Kirill
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There is no "payback" provision to return the removed funds to your IRA.

Well...

if you perform a "rollover" or "transfer" to yourself, you get 80% of the money, and if you can put the whole amount back within 90 days, there are no tax consequences. The only problem is you just loaned 20% of the money to Uncle Sam at 0% interest until you file your taxes.
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I believe first time homebuyers can withdraw up to $10,000 from an IRA penalty-free and the $10K will be taxed. If that's true, isn't the amount too low to matter? Put another way, I suspect the amount is too low to help significantly with the purchase but large enough to hurt the retirement nest egg. The 13.5% of my salary going into a 403b and long-term capital gains taxed at 5% lead me to think the 403(b) is not being maxed. Of course, OP didn't ask for advice on that and this is not the board for it, but one can't help noticing.

Any thoughts, corrections?
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If that's true, isn't the amount too low to matter?

A few extra thousand bucks can help a lot with liquidity. And since my downpayment is about $10K, it can help with the purchase too.

lead me to think the 403(b) is not being maxed

It is.

Any thoughts, corrections?

My thought is that my retirement is not my first investment priority after the 403b is maxed out, unless it provides an immediate tax benefit (such as, e.g., a fat retirement savings credit that someone with an AGI below $30K can get). I am ready to pay 5% in cap gain tax once in a while just for the sake of liquidity. Again, supposing I take out 10K from the IRA penalty-free, I can then put $4000 in my Roth and another $4000 in my wife's Roth, all in just one year. I probably wouldn't do it otherwise. But that way I have effectively done a conversion from traditional to Roth without invoking the 5-year rule for conversions. I am thus getting an option that I wouldn't otherwise have, and I also get an extra liquidity cushion (the Roth contributions will remain fully liquid).

Kirill
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You can NEVER recover your "base" once you withdraw it. You cannot make any contributions in excess of the annually allowed limit. There is no "payback" provision to return the removed funds to your IRA.

I can put more in a Roth than I intended to otherwise. In any case, what I intend to withdraw is only like 15% of the total.


And if you didn't withdraw the 10K, you could still put in more than you intended to. Work the numbers and you'll see how much you will lose and it WILL be substantial.

Diverting retirement funds to other purposes is rarely a good idea since most people significantly underfund their retirement.

Unless you have a great 403b with generous matching. I know this goes against common wisdom, but for many people in their 30-s (like me) the retirement may be the simplest part of the total financial picture. With 13.5% of my salary going into a 403b (including matching), I tend to think that's enough. And also, with the long-term capital gains taxed at 5% you really don't pay that much for liquidity anyway.


Congratulations on being able to save such a significant portion of your income. That puts you far ahead of most others your age. However,
I don't understand your reference to 5% capital gains. First off, that rate is only in place until 2007 (It's 0% for 2008 and 10% for years after 2008.) and only applies if your taxable income is fully in the 10 or 15% tax bracket. If your taxable income is that low, it's highly unlikely that your 403b will provide enough income for your retirement if you plan on retiring before you're in your 70's. Also, 403b distributions are taxable as ordinary income, not capital gains.

Ira
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There is no "payback" provision to return the removed funds to your IRA.

Well...

if you perform a "rollover" or "transfer" to yourself, you get 80% of the money, and if you can put the whole amount back within 90 days, there are no tax consequences. The only problem is you just loaned 20% of the money to Uncle Sam at 0% interest until you file your taxes.


Not even close. If you "rollover" an IRA to another IRA you get 100% of the funds and have only 60 days to return the money to the IRA. If you take a distribution from a 403(b) or other qualified plan, you only get 80%. However, most plans do not allow distributions unless you leave the job (though they may allow loans).

Nevertheless, none of this is relevant to the OP as it was clearly stated that the withdrawal was intended to fund the downpayment and the only question was how to document the use of the money so as to avoid the 10% premature withdrawal penalty.

Ira
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And if you didn't withdraw the 10K, you could still put in more than you intended to.

If you have the extra money.

5% ... that rate is only in place until 2007

If it goes up, I will reconsider.

If your taxable income is that low ...

Try to run the numbers. In 2005, for married filing jointly, 15% tax bracket applies to taxable income up to $59,400. Considering the deductions, exemptions, 403b contributions and tax-exempt benefits, the gross income must be over something like $85K to go to a higher bracket (disregarding the effect of capital gains at this point). The median household income in the U.S. is below $50K. Compared to that, $85K does not look that low. Take 13.5% yearly of, let's say, $70K and invest it in stocks for 35 years. Should suffice.

403b distributions are taxable as ordinary income, not capital gains

The same is true for the traditional IRA!

Kirill
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Take 13.5% yearly of, let's say, $70K and invest it in stocks for 35 years. Should suffice.

By my calculations that comes to around $2 million, assuming a 9% investment return. That may sound like a lot, but consider what 35 years of inflation will do, and that by 2040 you may have another 50 or 60 years to live on that $2 million, and it suddenly doesn't sound like very much.

While it's obviously all up to you, I would (and have) get out a spreadsheet and run a bunch of scenarios, including things like a flat stock market (so instead of $2 million, you end up with only $330,750 after 35 years).

Brian
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Brian,

You make valid points, but consider the following:

1. Salaries tend to outgrow inflation, which your calculation neglects.

2. If by 2040 people suddenly start expecting to live for 120+ years, they wouldn't retire at 70. Not working for 50 years sounds like a hell of a nightmare to me.

3. 9% return seems somewhat conservative.

4. Even accepting your calculation and assuming 3% inflation, you get about $700K in today's money in 35 years. Taking a return of 7% on that, you get about $50K annual income (today's money). Yes, it is taxed, but no FICA. Add to that the social security benefits that are likely to exist in some form at that time. The result seems to be more than sufficient, considering that one would likely to have some savings out of retirement accounts, no house payments, and plenty of home equity to leverage.

5. If the stock market is flat for 35 years (which is nearly impossible and something worth betting against), there's really no advantage to using tax-deferred accounts.

More is always better, but shifting too much income into retirement does not sound like a good idea to me. Before that, one has to pay off your home, send the kids to college, and use your cash flow for various "operating activities." Retirement funding should be adequate, but not excessive.

Kirill

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Not working for 50 years sounds like a hell of a nightmare to me.


Sounds like heaven to me.

But again we have the problem of people who can't fill a rainy Sunday afternoon praying for eternal life.

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Taking a return of 7% on that, you get about $50K annual income (today's money)

Kirill,

I think you have your situation pretty well in hand, but this is the one point i think is fairly dangerous. A safe withdrawal rate (SWR) is generally considered to be about 3 to 4%. 7% is awful high. That may seem silly if the market will return 9%, but, let's say you have $2 mil and right after you retire the market (or whatever mix of funds you have)has three 10% down years, and you do $140K withdrawl for those 3 years (in future dollars) - that's $2 mil - $140K * .90 - $140K * .90 ....


Now you are reduced to $1.11 mil, and in order to maintaining your intended lifestyle your withdrawl has been upped to 12.6%, higher than the market average. A couple more bad years and you've gotta go back to work. Even if you keep the 7% and reduce the amount, you're down to $1.17 mil and have nearly halfed your annual income. The fact is with a 7% withdrawl rate, you're relying on a lot of timing luck.

You may want to reconsider some of your assumptions about a SWR. However, I'm not saying that $2 mil is wrong either. There are many reasons why you'll need less than the typical ~80% of gross income often mentioned.

You may want to check out the FIREcalc (Financially Independent, Retire(d) Early) calculator and some articles on http://fireseeker.com/

Finally, my two sense, I would recommend avoiding the retirment accounts if at all possible. And before you do, do some number crunching - take out the amount of money that you could gain on having it in an IRA, including all fees, taxes, gains, etc and compare it to the reduced mortage and how much that'll let you put away extra and what that will turn back into.
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DeltaOne81,

Very true about 7%. If you want to be fully insulated, 3% is better. However, assuming 7% means you are not entirely in stocks. It's more like 50% in stocks, and 50% in bonds and CDs. This is something to plan carefully though depending on current bond yields, etc. And the stock selection must be appropriate. But that's doable, I believe, assuming one has some cushion elsewhere.

Finally, my two sense, I would recommend avoiding the retirment accounts if at all possible. And before you do, do some number crunching - take out the amount of money that you could gain on having it in an IRA, including all fees, taxes, gains, etc and compare it to the reduced mortage and how much that'll let you put away extra and what that will turn back into.

To this I violently protest! Heck, why would anyone want to pay off a loan at 5 or 6% instead of investing in stocks, having decades in front of you? The taxes don't count because mortgage interest is tax deductible; the fees are almost nil these days. Or why would anyone want to forego free matching in a 401k or 403b?

Kirill
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To this I violently protest! Heck, why would anyone want to pay off a loan at 5 or 6% instead of investing in stocks,

Well, let's see. The best investing minds in the world (including the likes of Warren Buffet) are expecting stock returns of 6% to 7% for the next decade or so. And that, of course, is not guaranteed. Your mortgage at 5% or 6% is a rock-solid guaranteed cost. That means your expected spread is between 0% and 2%. Those are pretty thin spreads.

Now, the question: Do you think you are as good an investor as those who have proven themselves as the best of the best over the last several decades?

--Peter
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The best investing minds in the world (including the likes of Warren Buffet) are expecting stock returns of 6% to 7% for the next decade or so. And that, of course, is not guaranteed. Your mortgage at 5% or 6% is a rock-solid guaranteed cost. That means your expected spread is between 0% and 2%. Those are pretty thin spreads.

I am sure I can get more than 7% from stocks during the next 30 years, but I don't insist on this. The big difference between the mortgage interest rate and the market return is that the former is simple, and the second is compounding. This difference will completely trounce the spread you are talking about after 30 years. Even if the rates are identical, investing will come way ahead.

kirill
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I am sure I can get more than 7% from stocks during the next 30 years,

How exactly do you intend on doing this? Details, please. Seriously. I'm always looking for good investment strategies.

The big difference between the mortgage interest rate and the market return is that the former is simple, and the second is compounding.

I think you misunderstand this a bit. The mortgage requires monthly servicing - monthly payments. You need a stream of cash flows to make the monthly payments. And if you happen to have a mortgage with negative amortization, the unpaid interest will indeed compound.

If you're comparing using mortgage proceeds and investing them to having neither, you need to account for the monthly debt service. That debt service needs to come from the investment returns. Hence, the compounding of investment returns is greatly reduced.

Alternatively, you can add money into the equation each month to make the mortgage payment. To keep things comparable, you would need to account for an additional monthly investment in your alternative (no mortgage) situation.

When returns are kept constant, you are correct that even a thin margin between the mortgage rate and the investment return is worth exploiting. But in the real world investment returns are not constant. An extended period of low investment returns, especially at the beginning, can keep things upside down for a very long time. In the end, it may come out ahead, but you are running a significant risk that something in you life will change and you need to access the funds before your plan has run it's course. A plan that is upside down for 25 years of a 30 year time frame is quite risky in my book.

--Peter
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To this I violently protest! Heck, why would anyone want to pay off a loan at 5 or 6% instead of investing in stocks, having decades in front of you?

No no no no no. Whoops. I wasn't clear. I meant that I would recommend avoiding taking money OUT of/taking a loan from the retirement accounts. I was most certainly not recommending avoiding using retirement accounts, for pete's sake no. I meant avoid the retirement accounts as a source of current funds, that's all. I just doubled my 401k contribution, I certainly understand the advantage of them.
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I am sure I can get more than 7% from stocks during the next 30 years,
How exactly do you intend on doing this?


I am sure an index fund will suffice. It has been like this historically. I don't think this is the right board to get into an argument about this, and that's just my opinion.

Regarding paying off the mortgage principal, I indeed made a mistake. Paying off principal is equivalent to a compounding investment at the same rate.

Kirill
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kdbel writes (in part):

The big difference between the mortgage interest rate and the market return is that the former is simple, and the second is compounding.

I reply:

Your reasoning is mistaken. The effective rate on your mortgage is compound. That is why, as time goes by, more and more of your payment retires principal. --Bob
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I am sure an index fund will suffice. It has been like this historically.

"History" includes the extremely abnormal period of 1980-today which has seen unjustifiably high stock returns. Stock returns theoretically should track corporate earnings. Lately they've been doing much better than corporate earnings -- and even the earnings numbers that are there don't account for the massive pension shortfalls at many corporations.
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