Six states now offer tax-advantaged homebuyer savings accounts and more may follow.
A tax-advantaged savings account makes it easier to save money that you use for specific purpose. If you’ve ever contributed to a 401(k) or IRA, you’ve used one of these accounts. There are also accounts that help you cover out-of-pocket healthcare costs and even transportation. Now, six states have programs that offer tax-advantaged homebuyer savings accounts that can help you overcome the common barriers to buying a home.
What is a tax-advantaged savings account?
A tax-advantaged savings account gives you a financial benefit for contributing money to save for a specific goal. There are three basic ways an account can offer money-saving tax benefits:
Tax free contributions: You don’t pay taxes on the money you contribute to the account; payments come out of your paycheck before taxes
Tax free earnings: You don’t pay taxes on the interest earnings from the account; basically any money the account earns is not taxed
Tax free withdrawals: You don’t pay taxes on the money you withdraw from the account.
A tax-advantaged savings account can offer one, two or (in rare cases) all three benefits. For example, a 401(k) provides tax free contributions, but you pay taxes on earnings and when you withdraw funds. By contrast, you don’t receive a tax break on contributions you make to a Roth IRA. However, both the earnings and withdrawals are tax free.
It’s worth noting, the health savings account (HSA) that was proposed during the healthcare reform debate offers all three. The Republican plan to replace Obamacare would provide a savings account that provided tax free contributions, interest earnings and withdrawals. This would be a huge benefit for households that could afford the high deductible healthcare plans required to enroll. This is one the primary benefits the Republican plan offered.
What are the advantages of homebuyer savings accounts?
Six states currently offer these accounts: Colorado, Iowa, Minnesota, Mississippi, Montana, Virginia; The benefits of the homebuyer savings account varies, depending on which state you live in. But they all focus on tax free contributions and earnings.
If you live in Mississippi, you enjoy both benefits.
- Colorado: Save up to $50,000 with tax free interest earnings
- Iowa: Tax free contributions up to $2,000 per year ($4,000 for married couples); interest earnings not included as income when filing taxes
- Minnesota: Tax free contributions up to $14,000 per year (double for married couples); state deduction on earnings
- Mississippi: Deduct contributions up to $2,000 from your adjusted gross income (AGI) or $5,000 for married couples; earnings are also tax-free
- Montana: Exclude up to $3,000 annually from your adjusted gross income; earnings are not taxed
- Virginia: Designate a specific account and save up to $50,000 that’s exempt from state taxes
In all cases, the tax exemption (at least for now) only applies to state taxes. That means the money and earnings may still be subject to federal taxes. The way these accounts offer tax free contributions is by allowing the taxpayer to lower their adjusted gross income. Lowering AGI lowers your tax obligation, so you owe less money for that year.
Homebuyer savings accounts only allow you to use the funds in the account for qualified home buying expenses. So, you can use the money to cover things like the down payment or closing costs. Uses also tend to vary by state. In some cases, these accounts are only available to first time homebuyers.
Finding benefits for homebuyers where you live
Homebuyer savings accounts are not the only way that states and municipalities try to help people become first time homebuyers. There are also down payment and closing cost assistance programs that can help pay all or part of these costs. Programs and available funds often depend where you want to buy your home. You may qualify for buying in a specific county or even a specific neighborhood.
As you can guess, knowing these programs exist can be almost impossible for you as a homebuyer. And even if your lender knows these programs exist, they are not required to tell you about these programs or help you enroll. So, how do you find these benefits?
A HUD-certified housing counselor.
Housing counselors are versed in programs that help homebuyers and homeowners in a specific state and area. They can tell you if there’s a homebuyer savings account available where you live. A counselor can also let you know if you have assistance programs available where you want to buy and how to qualify.
At the same time, they can help you make a plan that will improve your chances for mortgage approval. For instance, they can help you develop a strategy for reducing credit card debt so you can improve your debt-to-income ratio. It may take 12 months to a few years to save up and improve your ratio, but you’ll have a much better chance of booming a homeowner.