There are times in life when you need money urgently because you have an emergency on your hands. A lot of people usually borrow money from any source they can get their hands on.
However, your IRA account may not be the best place to get those funds from. While you may be tempted by the lump sum sitting in your Roth IRA, the IRS has specific regulations in place to prevent you from accessing those funds until the right time.
Do not get us wrong, though. The IRA money in your account belongs to you, the account holder, to do with as you please. If you want to clear out the entire account you can do just that.
However, there are very stiff penalties for doing that. You can be penalized up to 50% of your Roth IRA savings for breaching IRS rules! There are also income taxes that will be affected when you withdraw money early.
Surely this makes taking an IRA loan from your retirement savings a bad idea. If you need money urgently, your Roth IRA funds may not be the best source.
However, if you are reading this, you are obviously seriously considering a Roth IRA loan as a viable option. Whether it is for medical expenses or for any other reason, you need to read this before you withdraw money from your retirement accounts.
How to “Borrow” From an IRA
Strictly speaking, a Roth IRA loan does not actually exist. There are some 401(k) plans and employer-sponsored retirement plans that allow the account holder to borrow money and return the loan amount within a specified period.
A traditional IRA does not allow you to withdraw money from the retirement account at any time before retirement. If your Roth IRA funds are your only remaining option though, then you have no choice but to use the rules of the system to find a way to borrow from your IRA.
Using Rollovers for a Short-term Loan
When you fund your Roth IRA account using rollover funds from another account, there is a 60-day period during which your money is allowed to sit in your bank account before it is transferred to the same IRA you are about to open.
This two-month period is to allow the custodians of your retirement accounts enough time to set up your Roth IRA. However, you can use this time to your benefit if you think you can take a loan amount from the account, use it for your emergency, and return it to the same IRA funds within 60 days or less.
Conditions for 60-day rollovers
Income tax rules require your IRA provider to withhold 10% of the rollover money that is meant for your IRA retirement account.
When you pay back the IRA loan, you will need to return the full amount including the 10% that was withheld originally, otherwise, your loan will be counted as distributions and you will have to pay income tax as well as an early withdrawal penalty.
You are also allowed only one rollover per year, so if you have already done this then this door is closed until next year.
Check out our list of companies that can execute a gold IRA rollover.
Penalties for Failure to Redeposit Money
If you fail to re-deposit the money within 60 days, it not only means income tax is required, but a 10% penalty will also be imposed. This situation can also end up being a tax nightmare when the tax filing deadline finally arrives.
Roth IRA Withdrawals
The only time you can withdraw money tax-free from your Roth IRA is when you are over the age of 59 and your retirement account has been in place for at least five years.
If you do not qualify for these withdrawals, other conditions may allow you to access the money before age 59, such as:
Paying for qualified higher education expenses
Medical expenses (less than 7.5% of adjusted gross income)
Health insurance premiums if you are unemployed
Buying or building your first home
Disadvantages of Withdrawing From Your IRA
Your traditional IRA is meant to give you a source of income after you retire, meaning it is not structured in a way that makes it easy to withdraw funds before age 59. The following are some of the disadvantages of taking IRA loans before retirement age:
Getting slapped with penalties should be your biggest concern whenever you withdraw funds from your individual retirement accounts against IRS regulations.
The biggest risk here is that the IRS penalties can range from as low as 5% to 50% of your retirement account, making it very dangerous to withdraw money if you are not sure you can pay it back quickly.
Affects the Growth of Your Retirement Account
If you can leave a traditional or Roth IRA alone for many years without making any IRA withdrawals, you will give it time to grow to an amount that can sustain you in your later years. Getting into the habit of withdrawing funds might leave you in a situation whereby you retire having saved very little.
It Affects How You Pay Taxes
The reason why people choose to invest their savings in an IRA account in the first place is the various tax benefits it affords, such as your deposits being tax deductible. However, these benefits are only applicable if you adhere to IRS regulations that do not allow you to borrow from your IRA.
Is It a Good Idea To Borrow From an IRA Account?
The short answer is no; making IRA withdrawals before retirement age is not a good idea in any situation. There is a lot that can happen between the times you withdraw funds and the time your “IRA loans” are due.
Failure to pay back the money can have devastating consequences on your retirement plan. The best thing you can do for yourself when investing in traditional IRAs is to deposit money and forget it is even there until the day you retire.
Special Considerations Due to COVID-19
The COVID-19 pandemic affected many people and changes a lot of things in the financial industry. It would seem that the rules on borrowing money from your IRA account were also affected.
Faced with worsening financial consequences for ordinary people affected by the virus, the government passed the Coronavirus Aid, Relief, and Economic Security (CARES) Act in March 2020.
This Act was meant to provide qualifying retirement account holders with a little more freedom in terms of the nature of their IRA loans and the timeline for repayment. To be considered for the loan, one has to fulfill at least one of the following conditions:
You must have been diagnosed with COVID-19
Your spouse or dependent must be suffering from the virus
You have experienced a reduction in hours, furlough, inability to work, or laying off due to the pandemic
There is a proven inability to provide childcare due to COVID-19
Those who qualify can take up to $100,000 from their 401(k), 403(b), 457, or traditional IRA penalty-free. This means they will not be required to pay back an additional 10% on their loan. Furthermore, they are allowed three years to pay taxes on the loan or repay the entire amount into their account.
No law can force independent retirement plans to comply with this Act but it has been widely implemented. However, you should note that these regulations only apply to loans taken between January and December 2020.
What Is a Non-recourse IRA Loan?
There is another less-known option available to an IRA account holder to receive a loan on their retirement account. This is called a non-recourse loan and it can be offered to investors who wish to purchase a rental property. In this case, the loan is secured by the value of the property itself, rather than the IRA account holder.
Criteria for a Non-recourse IRA loan
It is not easy for just anyone to qualify for non-recourse IRA loans because they are only awarded under very strict conditions. To qualify, you must:
Demonstrate that you can generate positive cash flow from the real estate investment
Be willing to accept the steep 60% to 65% loan-to-value offered by most non-recourse IRA lenders
Have at least 15% of the value of the loan held as a cash reserve
What this means is that you must have at least 30% of the cost of the rental property you wish to purchase already held in your IRA just to cover the fees. With such expensive fees, the only time you should consider this option is if you are sure that the rental property will be able to quickly generate enough cash flow to cover the cost of the loan.
How Do These IRA Loans Work?
The process of securing a non-recourse loan is easy as long as you follow these steps:
Confirm that the account is eligible and provide all required documents, including recent statements and your spouse’s details, to the bank handling the loan
Review and sign all the relevant documentation and ask your custodian to sign the real estate contract
Transfer the funds necessary to cover the loan fees from your IRA to your bank account
You need to check that the IRA is listed as insured and that the policy covers at least a one-year term. All copies of the policy must be submitted at least 14 days before the day of closing the loan
You must now wait for the bank to review your documents and verify the availability of the funds before approving the loan
After approval, the down payment will be transferred by your custodian directly from your IRA to the title company handling the sale of the rental property
Alternatives To Making Early Withdrawals From Your IRA Account
Certain circumstances leave you with no choice but to borrow money. If that is the case, our advice is to consider the following alternatives to taking IRA loans:
Home Equity Loan
Using your home as collateral has the obvious risk of losing your house if you default on your mortgages, but this is the way most people finance their businesses or take care of medical expenses.
A lot has to happen before the day the bank comes to take your house away, so as long as you borrow a manageable amount, a home equity loan is a good option.
Unlike traditional IRAs, 401(k) will allow you to withdraw money without a penalty. Your loan repayments can also be done automatically from your salary meaning there is little risk of default. The only downside is that you are only allowed to take a loan of $50,000 from your account and this withdrawal will mean you lose out on the capital gains of the investment.
While personal loans come with high-interest rates due to the greater risk being taken on by the lender, they are still a great option for accessing a small number of funds. However, you should know that the fees and penalties that come with personal loans can greatly increase the cost of the loan. This means that the monthly repayments you will be required to make may end up being a lot more than you anticipated.
Borrow From Family and Friends
Your family and friends can be the best source of funds if you are in a tight spot. In fact, a lot of businesses have been started this way. Just be sure to not take advantage of them by not paying back the money on time as this could sour the relationship.
Withdrawing funds from your existing IRA should be your last resort after you have tried all other options, such as getting a personal loan, borrowing from family, or even getting a mortgage on your home.
However, if you have your heart set on making an early withdrawal from your IRA account, then make sure you know the consequences, as outlined in this article, and that you are ready to face them.