How Does an IRA Loan Work? - FOX21- Entertaining Delmarva One Click at a Time

How Does an IRA Loan Work?

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ira loan
If you’re like many people with an individual retirement account, the money in your IRA likely represents one of your largest assets. And if you find yourself in a tight financial spot, you may want to be able to borrow from that IRA before you reach retirement age.

If that describes you, there is good news and bad news.

The bad news is that you can’t actually take out a loan from your IRA. The Internal Revenue Service is plain about this: Plans based on IRAs (SEP, SIMPLE IRA) do not offer loans.

Nor can you put up your IRA funds as collateral for a bank or other loan. This action, as well as borrowing from your IRA, are examples of what the IRS calls “prohibited transactions.” The IRS further states that a disqualified person who takes part in such a  transaction must correct the transaction and pay an initial tax. Additional taxes may be applicable if the person does not correct the transaction in due time.

Alternatives to IRA Loans

The good news is that there is a way to take out what amounts to a short-term, interest-free loan from your IRA. You can do this by taking advantage of the rollover provision.

The rollover provision lets you withdraw funds from an IRA and use them at your discretion for 60 days. Then you can return the funds to the original IRA or a new retirement account all without any penalty, taxes or interest.

There are sizable catches involved. First, you have to return the money to a new or old IRA within 60 days. If you wait 61 days, unless you are age 59.5 or older, the entire amount you withdraw becomes subject to a 10% early withdrawal penalty plus any income taxes due.

If your age is more than 59.5, you can escape the 10% early withdrawal penalty, but you’ll still have to pay income taxes on the withdrawal. And it’s still important to wait no more than 60 days.

Another restriction is that you can only complete one rollover transaction in any 12-month period.

Penalty Exceptions

There are exceptions to the 10% penalty on withdrawals before age 59.5. If you need money because you have become totally and permanently disabled, you won’t face the 10% ding. Ditto if you need to pay for qualified higher education expenses.

If you’re a qualified first-time homebuyer, you can withdraw up to $10,000 without penalty. Also, if you have unreimbursed medical expenses, you may be able to withdraw penalty-free an amount equal to whatever is in excess of 7.5% of your adjusted gross income.

Transfers Involving a 401(k)

ira loan
The rule against loans doesn’t apply to all types of retirement accounts. For instance, you may be able to take out a loan from a 401(k) plan. Not all 401(k) plans permit this, but some do. If you have a self-employed 401(k), you may be able to do the same thing.

There is, of course, a potential catch here. If you don’t repay that 401(k) loan and you are under age 59.5, the amount of the loan will be treated as an early withdrawal. Again, you’ll be subject to the 10% early withdrawal penalty plus whatever income taxes are due.

Another way you can, in effect, borrow from your IRA is to move funds from your IRA into a 401(k) in what is called a reverse rollover. You’ll have to talk to your 401(k) plan administrator to find out whether and how you can do this.

The Roth Conversion

A Roth IRA is funded with after-tax dollars, so there aren’t any penalties or tax liabilities for withdrawals. You could convert your traditional IRA into a Roth IRA and then just withdraw the money you need.

The catch here is that you’ll have to pay income taxes on IRA funds that you convert to a Roth account. Also, you’ll have to wait five years after establishing the Roth before you can withdraw earnings from it tax-free. You can still withdraw the original amount you contributed, plus any additional contributions.

Bottom Line

ira loan
You can’t just take out a loan from your IRA or use it as collateral for a bank or other loan. But you can get short-term use of the funds for free, albeit at the risk of subjecting yourself to hefty penalties and taxes if you don’t approach it correctly.

You may also be able to switch the funds into a 401(k) and take out a loan or withdrawal, again with risks of taxes and penalties if you don’t pay the loan back on schedule. Roth IRAs may offer another option, at the cost of paying taxes now.

If you only need funds to cover an unexpected expense for a very short period, you might want to consider instead just charging the expense to a credit card. If you pay off the balance in full before your next statement date, which is normally not more than 30 days, your credit card issuer won’t charge any interest. This might be less risky and complicated than trying to tap your IRA funds.

Retirement Tips
  • Realize the importance of your IRA: In a true jam, you may need to back into a loan from your IRA, but it’s important to recognize that IRAs are important sources of income for retirement. Being able to manage the money in your IRA wisely is key to being able to support yourself after your working years. Knowing the rules around these accounts now can help you better prepare for the tax and savings consequences. To improve your understanding of how contributions, distributions and withdrawals work, consider working with a financial advisor. You can use SmartAsset’s free financial advisor matching service. Answer a few questions about your finances, and we’ll match you with up to three financial advisors in your area.
  • Government money: Don’t forget about Social Security. Use this Social Security calculator to estimate what you can expect your Social Security checks to be in retirement. After all, this money will play a role in your overall retirement budget.

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