If you withdraw amounts from your 401(k) plan or IRA before you are 59 1/2, the amount will be subject to income tax and a 10% early-distribution penalty. But what if you use those funds to purchase your first home? Well, if done properly, you may be able to avoid the 10% penaly.

Avoiding the penalty.  The IRS allows taxpayers to avoid the 10% early distribution penalty from a retirement account under certain circumstances. One of those exceptions is if IRA monies are used to purchase a taxpayer’s first home. The maximum amount that may be distributed from the IRA on a penalty-free basis for the purpose of buying a first home is $10,000. This is a lifetime limit.

Qualified expenses defined. Per the IRS, the funds must be used in the following manner to qualify:

• It must be used to pay qualified acquisition costs (defined later) before the close of the 120th day after the day you received it.
• It must be used to pay qualified acquisition costs for the main home of a first time homebuyer (defined later) who is any of the following.
  • Yourself.
  • Your spouse.
  • Your or your spouse’s child.
  • Your or your spouse’s grandchild.
  • Your or your spouse’s parent or other ancestor.
• When added to all your prior qualified first-time homebuyer distributions, if any, total qualifying distributions cannot be more than $10,000.
• If both you and your spouse are first time homebuyers each of you can receive distributions up to $10,000 for a first home without having to pay the 10% additional tax.

Qualified acquisition costs include the following items.

• Costs of buying, building, or rebuilding a home.
• Any usual or reasonable settlement, financing, or other closing costs.

Coordination of IRS Form 1099R with your plan administrator. Whenever one takes money out of a retirement plan, the plan administrator will report it to you and the IRS on Form 1099R. The codes in Box 7 will help one report what type of distribution was made and if there were any exceptions. If you are under 59 1/2 an will be using the amounts to purchase a home, while not required, it may be a good idea to let the plan administrator know. That way they can report the amounts with Code 2 on the 1099-R, which indicates that there is an exception to the 10% penalty.

How to make 401(k) funds penalty free. Even if a distribution form your 401(k) will be used towards the purchase of your first home, the first-time homebuyer exception does not apply to distributions from qualified plans such as a 401(k). Furthermore, if the amount you receive is rollover eligible, your employer is required by law to withhold 20% of it for federal income tax.

Assuming you are eligible to receive the distribution and the amount is rollover-eligible, you can instruct the 401(k) plan to process your distribution as a direct rollover to an IRA. You would have to open the IRA before the rollover occurs and tell them to deposit the funds to this new account (or your existing IRA). This will ensure that the 20% federal tax withholding is not applied to the amount. Additionally, you can then withdraw the amount from your IRA for use towards the purchase of your first home, thereby avoiding the 10% early-distribution penalty.

Properly reporting exceptions that were incorrectly reported. Sometimes despite letting the plan administrator know that the IRA funds will be used to purchase your first home, they may still be reported incorrectly on Form 1099R. Typically, this will result in Box 7 of the form indicating Code 1 – Early distribution, no known exception (in most cases, under age 59½).

However, if the funds were used to purchase your first home, there is a fix. One would need to use IRS Form 5329 Part I to report the exception. Specifically, one would list the amount reported on the Form 1099R on line one. You would then list the amount that was used to purchase the home (up to $10K during your lifetime) on line two and enter in exception Code 09 – IRA distributions made for the purchase of a first home, up to $10,000. For more details and specifics on the steps, see the Form 5329 Instructions.