IRA loans: Is borrowing from my IRA possible?

Unfortunately, there’s no such thing as an IRA loan, whether you have a traditional or a Roth account. While 401(k) accounts and other employer-sponsored retirement plans can allow participants to borrow and repay a loan over time, individual retirement arrangements, or IRAs, aren’t set up this way.

In fact, you can face IRS penalties if you withdraw funds from your IRA before age 59½. Under certain exceptions though, you may be able to withdraw money without paying a penalty.

But just because you can take money out of your IRA doesn’t necessarily mean you should. In addition to the potential costs, there are risks and some significant disadvantages.

Let’s look at the options, pros, cons and risks, so that you can make an informed choice about whether to borrow from your IRA.

Options for accessing IRA funds

Short-term rollovers

If you need a very short-term loan from your IRA and can pay back the money quickly — within 60 days or less — you may be able to access the funds with an IRA rollover.

Rollovers are often used to move money from a 401(k) or IRA to a new retirement account, like when you want to move to a different broker or consolidate multiple IRAs into one. With a rollover, you take the money out of your IRA and have 60 days to put it into another qualifying retirement account.

The IRS recognizes that people can change their minds about moving money between retirement accounts after they’ve taken a withdrawal from an existing IRA. So you’re also allowed to return withdrawn money right back into the same IRA instead of into a new one. If you do an indirect rollover — meaning the distributed money comes to you first instead of going directly from one IRA to another — you could potentially use the money for 60 days without penalty.

This approach has some significant risks and drawbacks, though. Here are a few.

• 20% “interest” — Technically, you won’t pay interest on rollover funds. But tax law requires IRA plan administrators to withhold 20% of indirect rollovers (when you cash out yourself) for taxes just in case you don’t complete the rollover. When you redeposit the money into an IRA, you’ll have to repay the full amount you withdrew, including the 20% you didn’t actually get. For example, if you indirectly roll over $5,000, you’ll actually receive $4,000 and be required to redeposit $5,000 within 60 days. That amounts to repaying your own funds at 20% “interest.”
• One-a-year limit — You’re only allowed to do one rollover within a 12-month period, so your ability to use this strategy is limited.
• Fees — Plan administrators may charge administrative fees for rollovers.
• Taxes and penalties — If you fail to redeposit the money within 60 days, the IRS will treat the transaction as an IRA distribution. The withdrawal will be taxed as income, and if you’re younger than 59½ you could also face a 10% penalty for making an early withdrawal.

Withdrawals for specific needs

While you’re generally subject to a 10% penalty for early withdrawals from an IRA if you take money out before age 59½, there are some exceptions to this rule.

You’ll have to pay ordinary income tax on your distribution but can avoid the 10% penalty. Here are some of these exceptions.

• Total and permanent disability of the IRA owner
• Qualified higher-education expenses
• Up to $10,000 for qualified first-time homebuyers
• Unreimbursed medical expenses that exceed 7.5% of your adjusted gross income
• Health insurance premiums while you’re out of work

Roth IRA withdrawals

Roth accounts work differently than traditional IRAs. When you deposit money into a Roth account, you make contributions with after-tax dollars. If you wait until retirement age and meet certain requirements, like having the account open no less than five years before withdrawals, you can take out money tax-free.

If you need to access funds from a Roth IRA prior to age 59½, you can withdraw the amount you put into the IRA without paying taxes or incurring penalties. This makes it possible to access money you put into your Roth IRA account anytime you need it. And if you withdraw funds from a Roth IRA before the tax-filing deadline of the same year you made the contributions, then they won’t count toward your contribution cap for the year.

But you have to be careful not to withdraw any earnings. If you withdraw money your investments earned, you’ll be subject to the 10% penalty unless you fall into one of the following exemptions:

• Permanent disability
• Buying or building a first home
• Paying for significant medical expenses (more than 7.5% of your AGI)
• Paying health insurance premiums while unemployed
• Paying for higher-education expenses

Drawbacks of IRA withdrawals

Although you can access the money in a traditional or Roth IRA, doing so often isn’t a good idea. There are two primary reasons why you don’t want to raid your IRA.

• You could face steep penalties. If you attempt to borrow from your IRA using the 60-day indirect-rollover method and don’t put the money back on time, you could get stuck paying the 10% penalty applied to early withdrawals. You could also face this penalty if it turns out you don’t fit into a hardship exemption or if you accidentally withdraw earnings and not just contributions from your Roth IRA.
• You lose out on potential growth. While the money is withdrawn, it won’t be earning returns and growing to help fund your retirement. And if you withdraw contributions from a Roth IRA that count toward your annual cap or take a hardship distribution from your traditional IRA, you can’t put the money back, so you lose out on all the gains it could’ve provided leading up to retirement.

Bottom line

Taking money out of your IRA, whether as a withdrawal or an indirect rollover that you plan to repay in 60 days, is a risky endeavor because of the potential taxes and penalties. Plus the loss of growth opportunity from the withdrawn funds could mean you face financial shortfalls as a senior.

Perhaps there’s a reason why there’s no such thing as an IRA loan — taking money out of a retirement account is borrowing against your own future financial security. Given the risks and disadvantages, raiding your IRA should be a last resort only after you’ve exhausted all other options.