The 1997 Taxpayer Relief Act allows one to take out a $10,000 distribution from the IRA without an early withdrawal penalty to buy a first home. If I had a traditional IRA, that's where the story would end. I'd just take out the $10K penalty-free. However, the Roth IRA adds a few twists of its own.
In a Roth IRA, this same $10K distribution is a qualified distribution, i.e. no penalty and no taxes on gains, if the Roth IRA has been open for more than 5 years. (Actually, it could be less than 5 years since the time period starts at the beginning of the first tax year for which a contribution was made to the Roth IRA, but I'm safely beyond this requirement.)
That's not the whole story either. A Roth IRA has ordering rules for distributions. Think of a Roth IRA as segmented into a few portions based on where the money came from. Any Roth IRA distribution will come from the first portion until it is exhausted. Then it'll come from the second portion until that is exhausted, and then the remainder will be distributed. The portions are as follows:
- Regular contributions. This is money I contributed to the Roth IRA from earned income. This portion is never taxed or penalized and can be withdrawn for any reason.
- Conversion and rollover contributions, e.g. converstion from a traditional IRA. This portion is not taxed or penalized after 5 tax-years. I haven't done any IRA conversions so I can disregard this.
- Earnings on contributions. Investment gains, if any.
So, if you have a Roth IRA, taking out just $10K for a first home purchase will likely not confer the expected tax benefit. If you have regular contributions in the pot, it would not be taxed when you take it out anyway and you didn't need the excuse of buying a home to do that. In order to really take full advantage of the $10K tax break, you'd have to withdraw all regular and conversion contributions plus $10K of Roth IRA earnings! That's essentially what Worksheet 2-3 says.
I've had a Roth IRA since 1998 and I've contributed as much as I could every year, so there is a substantial amount under "regular contributions". That amount plus $10K is a substantial fraction of a house now that prices have come down. With cash that I have already set aside, that means I'm pretty much set as far as financial arrangements go. And, of course, since I rarely get tax breaks, I ought to take this one. No hurry though. There is a time limit for use of the money after taking the qualified distribution so I shouldn't withdraw anything until I have contract in hand but it's something to add to the checklist.