US first-time buyers: IRA withdrawals, 401(k) loans and the MCC

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Kooky

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A buyer saving for a first home in the United States may hold part of those savings in an individual retirement arrangement, known as an IRA, or in a workplace plan such as a 401(k), where federal tax law normally charges an extra 10 per cent on money taken out early. The question is whether a home purchase changes that.

It does, but differently for each kind of account. This guide sets out what the Internal Revenue Service says in its own pages: Topic 557 on early IRA distributions, the instructions for Form 5329, its table of exceptions to the early distribution tax, its questions and answers on plan loans and hardship distributions, Form 8396 and Publication 530, Tax Information for Homeowners. It covers the IRA exception for a first home, borrowing from a workplace plan, hardship distributions, the Mortgage Credit Certificate, and the short list of purchase costs that reach the tax return. Everything here is federal; state income tax is a separate matter. Amounts taken from forms and publications are those printed for 2025 returns.

IRS Topic 557, IRS retirement plan pages on loans and early distributions, and Form 8396 for 2025.

Four tools that work in different ways

Three of the four tools are ways of reaching retirement savings early: a withdrawal from an IRA, a loan from a workplace plan, and a hardship distribution from a workplace plan. The fourth is a tax credit, the mortgage interest credit, which belongs to holders of a Mortgage Credit Certificate issued by a state or local government.

Each tool has its own gatekeeper. An IRA belongs to its owner, and the IRS notes in its hardship questions and answers that there is generally no limit on when an IRA owner may take distributions; the only question is the tax bill. A workplace plan is different: the same IRS pages say a plan may, but is not required to, provide for loans, and may, but is not required to, provide for hardship distributions. Whether either door exists is decided by the plan, not by the buyer. The certificate is issued by a state or local agency.

The IRA exception: what US$10,000 does and does not do

The starting point is the general rule. According to IRS Topic 557, a distribution received from an IRA before the owner reaches age 59½ is generally an early distribution, and the owner owes an additional tax of 10 per cent on the part of it that must be included in gross income. That 10 per cent comes on top of regular income tax; it does not replace it.

Topic 557 then lists the exceptions, and one of them is written for buyers: a distribution "not in excess of $10,000 used in a qualified first-time home purchase". The instructions for Form 5329 describe the same exception as IRA distributions for the purchase of a first home, up to US$10,000, and the IRS table of exceptions places it under section 72(t)(2)(F) of the Internal Revenue Code, in a row headed "Homebuyers".

Those pages give the figure and the label, and no more. The conditions behind the words "first-time" and "qualified" sit in a passage of Publication 590-B that could not be read for this guide: who counts as a first-time homebuyer, which costs and whose purchase qualify, how soon the money must be spent, and whether the US$10,000 is counted per year or over a lifetime. None of those conditions is stated here, and the exception should not be read as open to every buyer.

Two limits on that exception follow directly from the pages that were read.

The first is that it removes one tax only. The exception is an exception to the additional 10 per cent. Nothing in it changes the income tax on the withdrawal. Publication 590-B, the IRS guide to IRA distributions, states in its summary table that distributions from a traditional IRA are taxed as ordinary income, and adds that nondeductible contributions can make part of a distribution non-taxable. On a fully taxable withdrawal of US$10,000, what the exception saves is the additional tax: 10 per cent of US$10,000, which is US$1,000.

The second is the ceiling. A worked example, with illustrative figures: assume an owner under 59½ takes US$25,000 from a traditional IRA for a first home, that the whole amount is taxable, and that no other exception applies. The first US$10,000 is covered. The remaining US$15,000 is not, and the additional tax on it is 10 per cent of US$15,000, or US$1,500. The full US$25,000 is still income for the year.

One further figure matters to anyone whose retirement account at a small employer is a SIMPLE IRA. The IRS table of exceptions notes that a distribution from a SIMPLE IRA within the first two years of participation carries an additional tax of 25 per cent in place of 10 per cent.

Why a 401(k) is treated differently

The first-home exception does not belong to retirement accounts in general. The IRS table of exceptions has two columns, one for qualified plans such as a 401(k) and one for IRAs, SEP, SIMPLE IRA and SARSEP plans. In the "Homebuyers" row the first column reads "no" and the second reads "yes".

The table shows the mirror image for other exceptions. The exception for separation from service in or after the year an employee reaches 55 applies to qualified plans and not to IRAs, while the exceptions for higher education expenses and for a first home apply to IRAs and not to qualified plans.

For savings held in a workplace plan, that leaves the two routes the plan itself may offer: a loan, or a hardship distribution.

Roth IRAs and the two forms a buyer meets

A Roth IRA follows its own rules. Publication 590-B says in its opening summary that distributions from a Roth IRA are not taxed as long as certain criteria are met. The instructions for Form 5329 name the purchase of a first home, up to US$10,000, among the reasons listed in the rules for a qualified Roth distribution.

The same instructions set two requirements for a qualified distribution. It must be made after the five-year period beginning with the first tax year for which a contribution was made to a Roth IRA set up for the owner's benefit. And it must come under one of four heads: made on or after the date the owner reaches 59½, made because the owner is disabled, made to a beneficiary or to the estate after the owner's death, or made for the purchase of a first home, up to US$10,000. For a distribution that is early, the instructions give a general order: it is allocated first to the owner's Roth IRA contributions, then to conversions and rollovers on a first-in, first-out basis.

The paperwork runs through two forms. Publication 590-B says Form 8606 is generally filed when there are Roth IRA distributions, and according to the Form 5329 instructions a first-time homebuyer distribution is shown on line 20 of Form 8606. Form 5329 is then required in three Roth situations set out in its instructions: when line 25c of Form 8606 is more than zero, when the distribution includes a recapture amount subject to the 10 per cent additional tax, or when the distribution is a qualified first-time homebuyer distribution.

For a traditional IRA the route to the exception is Form 5329 as well. Its first part deals with the additional tax on early distributions, and line 2 asks for an exception number. The number for a first home is 09. Where more than one exception applies to the same return, the number is 99.

Whether the form is needed depends on Form 1099-R, the statement that reports the distribution: box 7 of that form carries a distribution code. According to the Form 5329 instructions, a taxpayer whose Forms 1099-R all correctly show code 1 and who owes the additional tax on the full amount does not file Form 5329 at all; the 10 per cent goes directly on Schedule 2 of Form 1040, line 8. A first-home withdrawal is the opposite case. Topic 557 says that a taxpayer who qualifies for an exception that the Form 1099-R does not identify, or identifies with an incorrect code, must file Form 5329 with Schedule 2 to claim it. The instructions add a third case: the form is filed when the exception does not cover the whole distribution, as in the US$25,000 example above.

Borrowing from a workplace plan

A loan differs from a distribution: the IRS questions and answers on plan loans treat it as taxable only when it breaks its terms. The page cites section 72(p) of the Internal Revenue Code and the Treasury regulations under it.

Loans are possible only from certain plans: qualified plans under section 401(a), annuity plans under section 403(a) or 403(b), and governmental plans. An IRA cannot lend. The IRS page is blunt about the consequence of trying: if the owner borrows from an IRA, the account stops being an IRA and its entire value is included in the owner's income.

The amount is capped by a formula. The maximum loan is the lesser of US$50,000 or the greater of US$10,000 or 50 per cent of the vested account balance. The IRS gives its own example: a participant with a US$40,000 balance can borrow up to US$20,000. A worked example with an illustrative balance shows the ceiling: with a vested balance of US$160,000, half is US$80,000, and the US$50,000 limit applies.

A second loan is possible. The IRS page says the new loan plus all outstanding balances cannot exceed the plan maximum, and that the US$50,000 ceiling is reduced by the difference between the highest loan balance during the previous 12 months and the balance now. Its example is a participant with a vested balance of US$100,000 who borrowed US$40,000 and still owes US$33,322. The difference is US$6,678, so the ceiling falls to US$43,322; taking away the US$33,322 still owed leaves US$10,000, which is the largest new loan the IRS example allows.

Repayment has three requirements. A loan generally must be repaid within five years. Payments must be substantially equal, must include principal and interest, and must be made at least quarterly. And here the home buyer gets a concession: a loan used to buy the participant's principal residence may have a longer repayment period. The IRS page does not put a number on that longer period.

A plan may also require the spouse of a married participant to consent to the loan, and may suspend repayments during military service or a leave of absence of up to one year, with the missed payments made up afterwards.

When a plan loan stops being a loan

A plan loan stays outside the rules for distributions only while it follows its terms. The IRS page describes two ways that ends.

The first is default. A loan that is not repaid as agreed is generally treated as a taxable distribution of the outstanding balance, called a deemed distribution. It counts for the early distribution tax, and it cannot be rolled over into another retirement account. Payments made after that point increase the participant's tax basis in the plan, the IRS says.

The second is leaving the employer, or the plan closing. If the plan reduces the account balance by the unpaid loan, the IRS calls that a plan loan offset. Unlike a deemed distribution, an offset is an actual distribution, and it may be rolled over. For offsets caused by the termination of the plan or by severance from employment, the deadline for the rollover, in force since 1 January 2018, is the due date of the federal income tax return for the year of the offset, extensions included. In other cases the usual 60-day rollover period applies.

Hardship distributions for a home purchase

The IRS questions and answers define a hardship distribution from a 401(k) plan as one made because of an immediate and heavy financial need of the employee, in an amount necessary to meet that need. The need may also be that of the employee's spouse, dependent or primary beneficiary.

Whether a need is immediate and heavy depends on the facts, the IRS says, but certain expenses are deemed to qualify. The list reads:

• certain medical expenses;
• costs relating to the purchase of a principal residence;
• tuition and related educational fees and expenses;
• payments needed to prevent eviction from, or foreclosure on, a principal residence;
• burial or funeral expenses;
• certain repairs to a principal residence that would qualify for the casualty deduction;
• expenses and lost income resulting from a federal disaster declaration.

A home purchase is on the list, and the wording is "principal residence", with no first-time condition.

The amount is limited to the need, and the need may include the taxes or penalties the distribution itself triggers. Since 1 January 2019 a plan may allow hardship distributions not only of the employee's elective contributions but also of the contribution types the IRS abbreviates as QNECs and QMACs and of safe harbor contributions, together with earnings; before that date the rule was limited to elective deferrals without earnings.

On paperwork, the plan specifies what the employee must provide. The IRS says an employer may generally rely on the employee's own representation of the need, unless it has actual knowledge that the need could be met another way, such as through insurance, by liquidating assets, by stopping contributions, through other distributions or plan loans, or by borrowing commercially.

The tax treatment is where a hardship distribution differs from a loan. It is includible in gross income, unless it consists of designated Roth contributions. It may be subject to the additional tax on early distributions, and the homebuyer exception is not available for a workplace plan. It is never repaid, so the account balance is reduced for good, and it cannot be rolled over into an IRA or another plan.

Other workplace plans follow their own rules. The IRS says the hardship rules for 403(b) plans are similar to those for 401(k) plans. A 457(b) plan, by contrast, may pay out only for an unforeseeable emergency, and the IRS states that buying a home generally does not qualify.

The Mortgage Credit Certificate

The fourth tool leaves retirement savings alone. Publication 530 describes the mortgage interest credit as intended to help lower-income individuals afford home ownership. It is a credit against tax, calculated on part of the mortgage interest the owner pays each year.

The credit exists only for someone who holds a qualified Mortgage Credit Certificate, or MCC, issued by a state or local governmental unit or agency under a qualified programme. Form 8396 spells out what does not count: certificates issued by the Federal Housing Administration, the Department of Veterans Affairs or the Farmers Home Administration, and Homestead Staff Exemption Certificates. The form sets three further conditions. The home must be the holder's main home. It must be located in the jurisdiction of the governmental unit that issued the certificate. And no credit is allowed on interest paid to a related person.

Timing matters. According to Publication 530, a certificate is generally issued only in connection with a new mortgage for the purchase of a main home, and the buyer must approach the appropriate agency before getting the mortgage and buying the home. The eligibility conditions of each programme are not described in the IRS documents read.

The certificate carries two numbers: the certificate credit rate and the certified indebtedness amount. Form 8396 says the rate must be between 10 and 50 per cent, and warns that it is not the interest rate of the mortgage. Only interest on the certified amount counts. Where the mortgage is larger than the certified amount, Publication 530 scales the interest down, and gives an example: a mortgage of US$125,000 with certified indebtedness of US$100,000 and US$7,500 of interest paid. The fraction is 80 per cent, so US$6,000 of interest enters the calculation.

Then comes the limit. If the certificate credit rate is 20 per cent or less, the credit is simply the interest multiplied by the rate. If the rate is higher than 20 per cent, the credit cannot exceed US$2,000 for the year. Two worked examples with illustrative figures, each assuming US$9,000 of interest on the certified amount: at a rate of 20 per cent the credit is US$1,800; at a rate of 30 per cent the multiplication gives US$2,700, the limit brings it down to US$2,000, and the US$700 above the limit is lost, because Publication 530 says amounts above the limit cannot be carried forward.

Co-owners share the limit in proportion to their interests. In the publication's example of a home owned 60 per cent and 40 per cent with a 25 per cent certificate rate, the limits are US$1,200 and US$800.

Working through Form 8396

The credit is claimed each year on Form 8396, attached to Form 1040, 1040-SR or 1040-NR. The 2025 form has two parts, and the first one produces the credit in five moves.

The form's Credit Limit Worksheet, used for line 8, starts from the tax on line 18 of Form 1040 and subtracts certain other credits. What cannot be used is not lost at once. Publication 530 allows the unused part to be carried forward to the next three years, or until it is used, whichever comes first, and gives an example: a credit of US$1,700 against tax of US$1,100 leaves US$600 to carry forward. The second part of Form 8396 works out that carryforward and is completed only when the credit allowed is less than the total available.

The credit has a cost on another line of the return. An owner who itemises deductions must reduce the home mortgage interest deduction on Schedule A by the amount on line 3 of Form 8396, and Publication 530 says this holds even when part of the credit is carried forward. In the 20 per cent example above, an owner who paid US$9,000 of interest and has a line 3 credit of US$1,800 deducts US$7,200.

A refinancing needs a new or reissued certificate, and Form 8396 lists the conditions: among them that the reissued certificate goes to the same holder for the same property, certifies no more than the outstanding balance of the old one and carries a rate no higher than the old rate. And a sale can trigger repayment. According to Publication 530, an owner who bought after 1990 with a certificate and sells within nine years may have to repay all or part of the benefit; Form 8396 refers such owners to Publication 523 and to Form 8828.

What reaches the return at purchase

The closing table produces a long list of payments and a short list of deductions. Publication 530 names three things a buyer can deduct for the year of purchase, and only when itemising on Schedule A: the buyer's share of real estate taxes, home mortgage interest including interest paid at settlement, and points, under the rules the publication sets for them.

The large cheques a first-time buyer writes are not on that list. Publication 530 says down payments, earnest money and forfeited deposits are not deductible; the down payment is part of the basis of the home. Insurance, including fire and title insurance, is not deductible, and nor are mortgage insurance premiums, for which the publication records that the itemised deduction has expired. Homeowners association fees and utilities are on the same list.

Some closing costs are added to basis instead, such as recording fees, surveys, transfer or stamp taxes and owner's title insurance. Others are neither deducted nor added to basis, among them loan assumption fees, the cost of a credit report and a lender-required appraisal fee.

A first home changes how an early IRA withdrawal is taxed. It does not change how an early 401(k) withdrawal is taxed, only whether the plan may release the money.

What the pages read for this guide leave open

Several points could not be confirmed from the IRS pages read for this guide and are left out on purpose. The detailed conditions of the IRA exception are set out in the "First home" passage of Publication 590-B, which could not be read in full: how the publication defines a first-time homebuyer, which costs and whose purchase count, how soon the money must be used, what happens when a purchase is delayed or falls through, and how the US$10,000 figure applies to a married couple. For a Roth IRA, this guide gives only the two requirements and the general order printed in the Form 5329 instructions; the fuller treatment in Publication 590-B, including how earnings are handled, was not read.

Three smaller gaps remain. The IRS loan page does not give a maximum repayment period for a plan loan used to buy a principal residence. Neither Publication 530 nor Form 8396 says whether the mortgage interest credit depends on itemising; they tie itemising only to the deduction that the credit reduces. And the form line numbers and dollar amounts drawn from Form 8396, the Form 5329 instructions and Publication 530 are those printed for 2025 returns.

Kooky, from Shaka

Kooky edits Agents Estate and builds Shaka, the payment router he made for real estate professionals. One payment comes in, and every agent, agency and party in the deal receives their signed share on closing date.

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