If you’re short on funds and have exhausted other options, you might consider borrowing money from your retirement plan. In some cases, this can be a cheaper alternative than using a credit card or taking out a personal loan. But if you’re not careful, it can cost you.
Many 401(k) accounts and other employer-sponsored retirement plans make it easy to borrow money and repay it over time, often with interest. However, with an individual retirement account (IRA), that’s not the case.
Still, some scenarios exist where you may “borrow” money from an IRA by withdrawing it and re-depositing it. In some cases, you can even withdraw from an IRA without penalties or interest. But before you begin, it’s essential to understand the risks and drawbacks, including potential IRS penalties.
Can you borrow money from an IRA?
No, you can not borrow money from an IRA, at least not in the traditional sense of taking out a loan. The IRS prohibits loans from a traditional or Roth IRA. Also, you may face penalties if you withdraw money from your IRA before age 59 ½ and don’t return it within 60 days. According to the IRS, early withdrawal usually triggers a 10% tax penalty, and the amount you withdraw is subject to federal taxes.
Important: If you don’t return money you withdraw from an IRA within 60 days, you could trigger a 10% penalty and be taxed on the amount withdrawn.
However, there are exceptions to the IRA early withdrawal penalty, allowing you to make early withdrawals from your IRA penalty-free. But you’ll likely have to pay income tax on the distribution.
- Hardship distribution: The IRS allows for a hardship distribution if you can demonstrate that you have “an immediate and heavy financial need.” You can only borrow the amount necessary to meet that need.
- Health insurance while you’re out of work: If you are unemployed and need to pay for health insurance, you may be able to withdraw money from your IRA without penalty to cover the cost of your premiums.
- Unreimbursed health care expenses: You may qualify to withdraw money from your IRA to pay for unreimbursed medical bills that exceed 7.5% of your adjusted gross income
- Qualified higher education costs: If eligible, you could receive this exemption and withdraw IRA funds to cover tuition, fees, books, and other education-related expenses.
- Disability: If you become totally and permanently disabled, you can withdraw from your IRA without incurring the usual early withdrawal penalty.
- Qualified birth or adoption distributions: You may qualify to withdraw up to $5,000 from your IRA within 1 year of the birth or adoption of your child without penalty.
- Terminal illness: If you’ve been diagnosed with a terminal illness with a life expectancy of less than 84 months, the 10% penalty tax does not apply.
What’s a 60-day rollover?
Rollovers are used to move retirement savings from one account to another without penalty. For example, you may want to consolidate multiple IRAs or switch to a different IRA provider.
Once you withdraw money from your IRA, you have 60 days to deposit it into another qualifying retirement account and have it be considered a rollover for tax purposes. The IRS also lets you re-deposit the funds in the same IRA account within the 60-day window without penalty.
If you only require money for a very short period, making an IRA withdrawal and then returning it could be an option. But there are certain factors that could make this a very expensive option if you’re not prepared.
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- Tax withholding: Cashing out funds yourself is considered an “indirect rollover,” and 10% of your withdrawal may be withheld for taxes. However, when you repay the amount, you’re expected to repay the full amount, including the 10% you never received. You can elect not to have any money withheld or have a different amount withheld.
- Annual limit: You can only rollover funds to another IRA account or back into the IRA you withdrew from once every 12 months.
- Taxes and penalties: You must roll over the funds within 60 days or the IRS will consider the withdrawal to be a distribution. Consequently, if you’re under age 59 ½, you’ll trigger a 10% penalty for the early withdrawal, and your funds will be taxed as regular income by the IRS (if not returned within the 60-day window).
Pros and cons of an IRA rollover
While using your IRA for a short-term loan can give you temporary access to funds, it’s not without risk. Weigh the pros and cons of borrowing from your IRA and consult with your financial adviser or tax accountant before making a decision.
Pros:
- Access to money you need: If you lose your job, qualifying for other forms of funding may be challenging.
- Potentially cheaper: If you need money to keep the lights on, borrowing from an IRA can be less costly than using a high-interest credit card or personal loan. Plus, you don’t have to put up your home as collateral as you do with a home equity loan or line of credit.
- No credit check: Indirect rollovers do not require a credit check, making it easier to access money if you have poor credit.
Cons
- Potentially more expensive: If you’re unable to repay the rollover within 60 days, your taxes and penalties could be significant if you’re under age 59 ½. Additionally, it could take longer to rebuild your retirement savings.
- Diminished retirement earnings: When you reduce your IRA balance, even temporarily, you diminish the earning potential of your account since your funds won’t earn interest while they are being used for the loan.
- Limited access: Technically, you can only borrow what’s available in your IRA, minus any income tax withheld. In reality, you should only borrow what you can expect to pay back within 60 days plus withheld taxes, or else face the resulting taxes and penalties.
What if you have a Roth IRA?
When you contribute to a Roth IRA, the government has already taxed the money you deposit. For that reason, you can withdraw up to the amount of your Roth contributions tax- and penalty-free at any age.
The key word to remember here is “contribution.” You will face a 10% penalty and income tax on any earnings you withdraw before age 59 ½ from a Roth IRA, unless you qualify for one of the exemptions listed above.
Alternatives to borrowing from an IRA
Withdrawing money from a traditional IRA (non-Roth) should only be considered as a last resort. Most employer-sponsored retirement plans allow you to borrow money and give you more time to pay it back. But avoiding tapping your retirement funds altogether can make personal loans an even better option.
401(k) loan
If your employer-sponsored 401(k) retirement plan allows you to borrow against your account, a 401(k) loan may make sense. You can borrow from your account without a penalty tax or income tax, and you don’t need good credit to be eligible.
The IRS allows you to borrow up to 50% of your vested balance with a cap of $50,000. The catch is you must repay the amount you withdraw plus interest within five years, or the withdrawal will count as a distribution, and you’ll be hit with a penalty and taxes. If you leave your job, you could have to repay your loan at a much sooner date, depending on your plan. If your plan doesn’t specify a repayment deadline, the IRS states you must repay your loan before your income taxes are due the following year.
Personal loan
Many experts recommend against borrowing from your retirement plan, as it reduces your retirement account’s growth potential. If you need money to consolidate debt or to get through a rough financial spot, a personal loan may be a better option. Shop and compare APRs for the best personal loans and see if the numbers make sense.
Related: Learn more about getting a personal loan on Credible.com
