Borrowing From Your IRA

Looking for an interest-free loan for 60 days or less? One option is to borrow from your IRA.

Done right, it’s a tax-free deal, and you won’t incur any interest charges. Done wrong, you'll trigger income taxes and maybe a 10% penalty too while decimating your retirement stash.

The way it works is this: You take the money out of your traditional or Roth IRA and then replace the cash (the same amount that you withdrew) within 60 days. Make sure to put traditional IRA money back into a traditional IRA, and put Roth IRA money back into a Roth IRA. You must also comply with the one-year rules explained below. If you do these things, the withdrawal of IRA money and subsequent redeposit is treated as a tax-free rollover transaction -- even though it's effectively the same as taking out and repaying a short-term loan from your IRA.

Here are a few things to watch out for:

The 60-day rule is no joke. The money you’ve withdrawn (borrowed) must be redeposited back into an IRA within 60 days. Otherwise, the withdrawal is treated as a garden-variety taxable distribution, and you can't put the money back into your account. To add insult to injury, you’ll generally face an additional 10% penalty tax if you’re under age 59½, and you may owe state income tax, too. So avoid unnecessary stress by redepositing the money with at least a day or two to spare. Just so you know, the 60-day period starts on the day after you receive the withdrawal (the borrowed amount).

Example 1
Say you want to take advantage of the borrow-from-your-IRA strategy by withdrawing some money on 10/1/08. The 60-day period begins on 10/2/08, and it ends on 11/30/08. No extension is allowed for weekends or holidays. In this example, 11/30/08 happens to fall on a Sunday. So you would be well-advised to get your redeposit completed by no later than 11/28/08, which is a Friday.

Two tax rules are designed to prevent folks from repeatedly using the tax-free short-term IRA loan strategy with the same accounts. If you run afoul of these rules, all the tax advantages are lost.

First, you can only take a withdrawal from a particular IRA and then redeposit the money tax-free (into that account or another one) once during any one-year period. If you withdraw money from the same IRA twice during a one-year period, the second withdrawal is treated as a garden-variety taxable IRA distribution. That means it can't be redeposited, so you will owe income taxes and possibly a 10% penalty.

Second, if you’ve redeposited money back into a particular IRA, any money withdrawn from that account within one year is treated as a taxable distribution with the same dire tax consequences.

For purposes of both of these rules, the one-year period starts on the date you receive an IRA withdrawal, (not on the date you redeposit the amount back into an IRA).

Hopefully, these complicated one-year rules won't matter to you, but here’s an example just in case:

Example 2
Say you have three traditional IRAs: IRA-1, IRA-2, and IRA-3. After reading this brilliant article, you decide to do the short-term tax-free loan deal by withdrawing $10,000 from one of your IRAs on 10/1/08 and then redepositing the money by no later than 11/30/08 to comply with the 60-day rule (see Example 1).

However, that’s not necessarily the end of the story. Say you previously took money from IRA-1 on 4/1/08 and then redeposited it back into IRA-2 tax-free on 5/30/08. Let’s assume IRA-3 hasn’t had any such activity in recent years. Under the first one-year rule, you can’t take any more money out of IRA-1 before 4/1/09 if you want to get tax-free treatment by putting it back into an IRA. Under the second one-year rule, you can’t take any money out of IRA-2 before 4/1/09 if you want to redeposit that money tax-free.

Therefore, in this example, you must withdraw the $10,000 out of IRA-3 to successfully execute a tax-free deal. Why? Because no amount has been taken out of IRA-3 within a year of 10/1/08 and put back (so you’re good on the first one-year rule). Nor has any amount been redeposited into IRA-3 within a year of 10/1/08 (so you’re good on the second one-year rule, too). To avoid any further possibility of error, I recommend putting the $10,000 back into either IRA-3 or a new IRA created to receive the money. Finally, you won’t be able to take any more money out of IRA-3 before 10/1/09 if you want to redeposit that money tax-free.

Good question. You must report the entire amount of any IRA withdrawal on line 15a of your Form 1040 for the year of the withdrawal. If you then redeposit the amount tax-free, you enter a taxable amount of zero on line 15b. Write “Rollover” next to line 15b. Now the IRS has been properly notified about your tax-free short-term IRA loan deal, and everyone is happy.

Given the potential tax traps, you may want to look for other alternatives before using this strategy to solve short-term cash flow problems. But done right, you won’t find a better deal.