IRAs and Loans Don’t Mix

Tuesday, September 23, 2014

By Joe Cicchinelli, IRA Technical Expert
Follow on Twitter: @JoeCiccEdSlott

Since you have unlimited access to your IRA funds, you might be tempted to use your IRA for personal use. While you are allowed to take an IRA distribution at any time, and for any reason, the IRA distribution will be taxable to you if you don’t roll it over within 60-days of receipt. So, in order to avoid having to pay federal income taxes on an IRA distribution, you might think to try and take a loan from your IRA instead. Unfortunately, taking a loan from your IRA could actually cost you MORE in taxes than taking an IRA distribution.

The Tax Code does NOT allow you to take a loan from your IRA. If you do take a loan from your IRA, the Tax Code treats the loan as a prohibited transaction. The penalty for engaging in a prohibited transaction is that your entire IRA is considered disqualified. Your entire IRA balance, not just the loan amount, is deemed paid out (distributed) to you on January 1st of the year you took the loan.

Example:

Let’s assume you have an IRA with a $100,000 balance on January 1st of this year. You set up a loan in your IRA for $25,000 this year. Your entire $100,000 IRA is disqualified and the entire balance is treated as a taxable distribution to you for this year. Also, if you’re under age 59 ½, a 10% early distribution penalty will apply.

In the example above, it doesn’t matter if you repay the loan to try and fix the problem. Repaying the loan doesn’t MATTER and won’t reinstate your IRA. It also doesn’t matter if you used the loan proceeds for a bona fide financial hardship, such as to pay bills because you lost your job.

 

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