Can You Take a Loan Out on an IRA?
Understand if you can borrow from your IRA, the serious consequences of missteps, and the correct ways to access your retirement funds.
While the desire to access funds from retirement savings can arise from various financial needs, direct loans from an Individual Retirement Account (IRA) are generally not permitted by the Internal Revenue Service (IRS). Understanding the rules governing IRA access is important to avoid penalties and tax consequences.
The General Rule for IRAs
IRA owners are generally prohibited from taking loans directly from their accounts. This restriction stems from IRS regulations that classify such actions as “prohibited transactions” under Internal Revenue Code Section 4975. An IRA is established as a trust or custodial account for the owner’s retirement benefit, not as a personal lending institution.
Treating an IRA as collateral for a loan, or directly borrowing from the IRA, constitutes a prohibited transaction. These rules apply to all types of IRAs, including Traditional, Roth, Simplified Employee Pension (SEP), and Savings Incentive Match Plan for Employees (SIMPLE) IRAs. The intent behind these regulations is to prevent individuals from personally benefiting from the tax-advantaged status of their retirement accounts in ways not intended by law.
Consequences of Misusing IRA Funds
Engaging in a prohibited transaction, such as attempting to take a loan from an IRA, triggers tax and penalty implications. If an IRA owner or beneficiary participates in a prohibited transaction, the entire IRA is treated as distributed on the first day of the year the transaction occurred. The full fair market value of the IRA becomes taxable as ordinary income for that year.
In addition to ordinary income tax, the account holder may face a 10% early withdrawal penalty if under age 59½. Excise taxes are imposed on the “disqualified person” involved in the prohibited transaction, initially a 15% tax on the amount involved, which can increase to 100% if not corrected promptly.
Understanding Allowable IRA Withdrawals
Since direct loans are not an option, individuals needing to access IRA funds must do so through legitimate withdrawals, also known as distributions. These distributions are typically subject to ordinary income tax. If the account holder is under age 59½, a 10% early withdrawal penalty usually applies to the taxable portion.
There are several exceptions to the 10% early withdrawal penalty. These exceptions include distributions made:
- After the IRA owner reaches age 59½
- Due to death or total and permanent disability
- As part of a series of substantially equal periodic payments (SEPP)
- For qualified higher education expenses
- For a first-time home purchase, with a lifetime limit of $10,000
- For unreimbursed medical expenses exceeding a certain percentage of adjusted gross income
- For health insurance premiums during periods of unemployment
- For qualified reservist distributions
Distinguishing IRA Access from 401(k) Loans
Confusion often arises regarding retirement plan loans because the rules for IRAs differ from those for employer-sponsored plans like 401(k)s. While IRAs generally do not permit loans, many 401(k) plans do allow participants to borrow against their vested account balance.
A 401(k) loan functions as a loan to oneself, with interest paid back into the account rather than to an external lender. The maximum loan amount is typically limited to the lesser of $50,000 or 50% of the vested account balance.
Repayment terms usually range up to five years, though longer periods may be permitted for the purchase of a primary residence. These loans often feature payroll deductions for repayment and generally do not require a credit check.