We tapped our IRA to buy a home for cash. Should we borrow to repay the IRA or take the tax hit?

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Dear Credible Money Coach,

We paid cash for our home, but withdrew $200,000 from an IRA to help with the cash deal. The $200,000 should be paid back in 60 days, or there will be 10% tax due in April.

We could ask for an equity loan to pay it back now, or wait until April, and save enough to pay the 10% tax. All our income is tax free, so the only tax will be $20,000 (10% of $200,000). Our annual tax-free income is about $75,000.

Which would be the best alternative?— Jan, Nevada

Hi Jan! Thanks for your question, and for providing us with some additional information in response to our email to you. Your question is interesting and unusual! While I’ll do my best to share with you what I know of tax rules that seem to apply to your situation, I strongly recommend you consult with a trusted tax professional before deciding how to proceed.

First, congratulations on paying cash for your house! Not having a mortgage payment is a huge financial advantage, especially when you’re approaching retirement age — as you told us you’re older than 59½.

You also told us the house you purchased was $590,000 — $390,000 came from savings and $200,000 from a SIMPLE IRA. And, from the additional information you provided, it sounds like you don’t typically owe state or federal income tax on your $75,000 income. Keep in mind that any income you don’t pay tax on can still be considered taxable, at least at the federal level — Nevada, where you live, doesn’t have state income taxes.

So for the purposes of answering this question, we need to focus on federal tax implications.

What the IRS says about IRA withdrawals

The idea behind tax-advantaged retirement accounts like a SIMPLE IRA is that you put money into your retirement account when you’re actively earning and are in a higher tax bracket. Then, when you retire and are no longer an active earner, your tax bracket will likely be lower and you’ll pay less tax on the money than you would’ve paid when you were still working.

Money you take out of a SIMPLE IRA isn’t considered a loan. It’s considered a withdrawal, and that amount will generally be subject to federal income tax. But you may be able to put that money back into your IRA and avoid tax implications under certain circumstances.

Generally, you can take money out of a SIMPLE IRA and not pay tax on it if you roll that money into another IRA within 60 days. And, because the IRS recognizes that people sometimes change their minds about opening a new IRA, you can usually put the money back into the original IRA within 60 days and avoid federal income tax on the amount.

Tax implications of IRA withdrawals

Remember, when you put money into the IRA, it was pre-tax, so you’re generally expected to pay tax on it when you withdraw it. That said, not all money withdrawn from an IRA is considered taxable and the rules for determining what is and isn’t are pretty complex.

The 10% you refer to in your initial question is actually a penalty that usually applies, in addition to regular income tax, if you withdraw money before you’re 59½. Since you’re over that age threshold, that penalty shouldn’t apply in this case. So the amount you could owe wouldn’t be $20,000 — 10% x $200,000.

You could owe more, and here’s why.

Your $200,000 withdrawal will likely be considered taxable income if you don’t return it to your IRA in the required time frame — even though your other income hasn’t been subject to federal income tax in the past. The tax rate that will apply to your withdrawal will be calculated based on your total income for 2021, including your $75,000 regular income, the $200,000 withdrawal, and any other taxable income you receive this year.

Based on this information, it’s probably a good idea to return the $200,000 withdrawal back to your IRA within 60 days — or you could be facing a significant tax bill come April 2022. And, since the IRS expects you to pay at least 90% of the tax you owe in any given year by the tax filing deadline for that year, if the tax you owe is more than 10% of your total tax obligation, you could be subject to an underpayment penalty.

Repayment options

You asked if you should take out a home equity loan for $200,000 to repay the money you withdrew from your IRA. This may be an option if you can find a lender willing to allow you to tap that much equity.

Generally, lenders will allow you to borrow up to 85% of your home’s value, less whatever you owe on a mortgage. Since you don’t have a mortgage, your home equity is $590,000, and 85% of that value is $501,500 — far more than you’d need to borrow to repay your IRA withdrawal. Of course, other factors will also come into play when a lender decides how much it’s willing to loan you.

Based on the score range you shared with us, I’d say your credit is good to excellent, and you may be able to qualify for a favorable home equity rate. Right now, interest rates overall are low, but rates for home equity loans can vary widely depending on lenders, your credit, and a host of other factors.

If you decide to go this route, be sure to comparison shop for loans from multiple lenders to improve your chances of finding the best possible interest rate and loan deal.

A last word ...

As I said at the beginning of this column, it’s a good idea to consult with a tax professional whenever you encounter a situation that could have significant tax consequences. Check with your accountant or another financial advisor you trust to discuss the options that will minimize the impact on your taxes and overall financial well-being.

This article is intended for general informational and entertainment purposes. Use of this website does not create a professional-client relationship. Any information found on or derived from this website should not be a substitute for and cannot be relied upon as legal, tax, real estate, financial, risk management, or other professional advice. If you require any such advice, please consult with a licensed or knowledgeable professional before taking any action.

About the author:

Dan Roccato is a clinical professor of finance at University of San Diego School of Business, Credible Money Coach personal finance expert, a published author, and entrepreneur. He held leadership roles with Merrill Lynch and Morgan Stanley. He’s a noted expert in personal finance, global securities services and corporate stock options. You can find him on LinkedIn.