It is often tempting to take a loan or withdrawal from a retirement account to satisfy a financial need such as making a down payment on a house or paying off another debt. Taking such loans and withdrawals is highly discouraged as it depletes retirement savings and can have significant impact on these retirement savings in the long run. It is a serious decision which should not be taken lightly. In cases where retirement savings must be accessed prior to retirement, a loan has an advantage over a withdrawal in that it will not result in taxable income as long as it is paid back according to its terms. However, certain retirement accounts allow loans while others do not. This article will discuss the rules applying to different types of retirement accounts.
IRA loans – generally prohibited
Generally a loan can not be taken using an IRA. Using an IRA as collateral for a loan is prohibited by IRS rules, and can result in the IRA becoming disqualified. There is an IRS provision which allows 60 days to rollover or transfer an IRA to another custodian if the distribution from the IRA is paid directly to you. Keep in mind that in this scenario the taxes are withheld from the distribution so you will need to supply additional funds to complete the rollover or transfer.
401K loans – take with caution
In many cases a 401K participant can take a loan against their 401K account balance, if the particular plan allows loans. You can check the plan document or summary plan description, or check with your company’s HR department to see if a loan is permitted. Taking such a loan is usually quick and easy and is not subject to any underwriting processes. The installment payments made on the loans are usually made through payroll deduction from the participant’s paycheck. 401K loans must be paid back according to their terms in order to avoid being deemed to be a distribution and thus subject to taxes. The loan terms are usually five years or less, unless the loan is used to purchase a primary residence, in which case it can be longer. Keep in mind that if you are separated from service with your employer while the loan is outstanding, it must be paid back in full according to its terms, usually within 60-90 days of termination, or be deemed to be a distribution and thus be taxable. “Interest” which is charged on the loan is typically paid back into the participant’s account as payments are made.