Borrowing from Your Individual Retirement Account

July 26, 2019

One of the most frequently asked questions I receive from clients revolves around the rules governing borrowing from your IRA, or individual retirement account. Taking a distribution from your account can avoid taxation if it is paid back within the 60-day rollover regulations. The rules are somewhat complex and must be carefully followed by the letter of the law or the distribution will be taxable.

First and foremost, only one rollover per twelve-month period is allowed, no matter how many individual retirement accounts you own.

The last withdrawal from your account is the one considered by the Internal Revenue Service as the rollover amount they will allow you to replace without income tax or penalties if you follow all the rules properly.

There are several ways people get themselves into unexpected tax consequences by not thinking ahead before they pull money from an individual retirement account intending to pay it back in time and avoid the tax pain. The most common problem is not taking enough money to accomplish your funding needs in one pull from your account within a 60-day period.

Let me give an example.

Mr. and Mrs. Retired Couple want to buy a new home. Their current residence is in escrow and is expected to close in 45 days. They have found the new house of their dreams and need a $40,000 down payment to tie it up until their current home closes escrow. They decide to pull the $40,000 from their individual retirement account intending to pay it back within the required Internal Revenue Service time limits. But they forget that they will need an additional $2,500 per month to pay their normal bills each month. They also need other funds to pay the moving company. Two weeks after pulling out the $40,000 they pull an additional $2,500 to pay their normal bills, and another week later they pull $5,000 for the moving company and finally they pull another $2,500 to pay their normal monthly bills for the next month.

Can they roll back the $40,000 into their individual retirement account without income taxes? The answer is no, they cannot. Only the last amount pulled from the individual retirement account of $2,500 is eligible for replacement back to the account. For them to have been able to pay back the $40,000, they should have first pulled two months of living overhead of $5,000 and the sums needed for the move of $5,000. After those two sums were out of the individual retirement account, then they could have pulled the $40,000 from the account but take no further funds from the account for the next 60 days or until they paid back the sum of $40,000 into their individual retirement account.

Planning is paramount if you need to borrow from your individual retirement account and you are already taking regular distributions.

In this unfortunate situation, the only slight tax solution to reduce their future tax liability was for Mr. and Mrs. Retired couple to use the $40,000 proceeds from their house to live on for the next sixteen months, thus eliminating their withdrawals from their individual retirement account for that period. However, it can still hurt if the unusually large withdrawals in one year put them into a higher tax bracket.

The 60-day period starts on the day the funds are pulled from your account, not the date on which you receive the check in the mail or pick it up from your custodian.

The date on the check is the start of the rollover period. The funds must be back in the account before 60 days pass. In other words, you only get 59 days to use the funds, not 60. If the 59th day falls on a weekend or a legal holiday, then the period in which you must replace the individual retirement account distribution is shortened. There are no extensions or exceptions. Be cautious and replace it well before the deadline. Financial institutions will not credit it back to the individual retirement account the same day of delivery if your check is received after normal deposit hours. The replacement must be deposited 59 days or before for it to be considered repaid in a timely manner.

If you have multiple individual retirement accounts, the replacement must be paid back to the same account from which you borrowed.

The account must also reside within the same institution from which you borrowed the funds. You cannot transfer your account from one bank or broker dealer to another and then replace the funds to a different institution, even if you made the replacement within the mandatory time frame.

The last common trap is borrowing from a beneficiary individual retirement account and thinking you can replace using the 60 day rule. Beneficiary accounts are not eligible for the 60-day rule. Whatever you withdraw from a beneficiary account is going to be fully taxable.

The most painful of all circumstances is borrowing from your individual retirement account and not paying it back in time if you are under 59.5 years of age.

Such withdrawals are treated by the Internal Revenue Service as “premature distributions” subject to an extra ten percent penalty tax. The State of California also levies a penalty of an additional two and a half percent. Not only is the distribution still fully includable in your taxable income, but the additional associated penalties are a whopping 12.5 percent in addition to the income taxes owed.

If you are considering taking a distribution from your individual retirement account using the 60-day rule consult with your financial or tax advisor before pulling the funds. The rules are complex and more extensive than the limited issues discussed in this article.

Proper guidance will help you avoid giving Uncle Sam another payday.

Originally Published on The Union
Written by Mary Owens