Be Careful About Using Your IRA for a Short-Term Loan
By Ian Berger, JD
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Thinking of using your IRA as a “short-term loan” to raise some extra cash for the holidays? What could go wrong? Well, actually, two major things could go wrong. And either could lead to serious tax headaches.
Let’s say Chloe started her holiday shopping early this year and, as usual, spent more than she had budgeted. Now the credit card bill is coming due and she’s scrapped for cash. Chloe is expecting a year-end bonus from her employer that is usually paid in late January.
Chloe looks around at her savings options and quickly considers her IRA. She knows she can withdraw from the IRA and pay it back with 60 days without getting hit with taxes or penalties. She also knows the IRS doesn’t care what she does with the withdrawn IRA funds, as long as she pays back the same amount on time.
So, Chloe withdraws $25,000 on December 10, 2020 and uses it to pay off her credit card, avoiding late fees. She knows that she has until February 9, 2021 to return the $25,000 to her IRA. Her bonus has always been more than that, so she’ll have more than enough cash to pay it back.
Here are the two potential issues that could derail Chloe’s plan:
First, the rollover back to the IRA might violate the “once-per-year-rollover” rule. That would occur if Chloe had received another distribution in the prior 12 months (i.e., since December 10, 2019) that she rolled over in an IRA-to-IRA or Roth IRA-to-Roth IRA rollover. (The once-per-year rule doesn’t apply to company plan-to-IRA or IRA-to-company plan rollovers or to Roth conversions.) Unlike other IRS rollover rules, there is no way to correct a violation of the once-per-year rule.
Second, Chloe might not be able to return the IRA by February 9. What if her employer cuts back its bonus after a tough year? Even worse, what if she’s laid off after the first of the year? Or, what if she simply forgets to do the rollover on time? The IRS will sometimes grant an extension of the 60-day deadline, but it won’t be forgiving if the IRA funds were used for personal reasons. There’s also an IRS program (called “self-certification”) that allows late rollovers without going to the IRS for relief. But self-certification is only available for certain specified reasons (e.g., you or a family member was seriously ill, or the IRA custodian messed up). Not being able to come up with the money to repay a withdrawal in time doesn’t qualify.
Violating the once-per-year rule or missing the 60-day deadline both have serious tax consequences. First, the rollover amount will be considered a taxable distribution, in this case adding $25,000 of taxable income to Chloe’s 2020 tax bill, which will hit very soon. Second, if Chloe is under age 59 ½, a 10% early distribution penalty ($2,500) would apply. Finally, a failed rollover could be considered an excess contribution in the receiving IRA that would subject her to a 6% annual penalty unless timely withdrawn.
Consider yourself warned!
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