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The risky IRA ‘loan’ clients ask for

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Clients in need of a short-term cash influx may be tempted to dip into their IRAs and repay themselves rather than seeking out a lender. Often, they’re under the impression that tapping an IRA works like taking a loan from a 401(k). The reality is much more complicated.
Any money your client withdraws from an IRA must be deposited back into the account or another IRA within 60 days of receiving the distribution. Otherwise they could owe taxes on the sum. If they are under 59 1/2, there may be an additional 10% tax penalty. Clients who tap a Roth IRA’s earnings could be in the same position, and they can only make one such rollover in any 12-month period, regardless of how many IRAs or Roth IRAs they own.

With such a short borrowing window, it may seem like this risky strategy wouldn’t appeal to clients, but several advisors say they’ve have fielded inquiries about it. If you’re in a similar boat, here’s how to help clients who are set on the idea of taking and then undoing a distribution.

“I don’t recommend this type of thing to clients,” says advisor Chris Baker, co-founder of Oaktree Financial Advisors in Carmel, Indiana, but nonetheless he has advised a couple people who went through with withdrawals. “I’ve seen this mostly centered around real estate transactions, like when someone wants to purchase a new home but hasn’t closed on their current home. They need to get their hands on money now but believe when the home does sell they will have the funds to put back.”

Other reasons some clients have pursued this path include: having no 401(k) to borrow against and expecting a tax payment within 60 days to offset the expenses they’re borrowing for.

The biggest fear surrounding these short-term borrowing moves is that well-meaning clients, who have every intention of putting the money back, will fail to do so. Baker recounts one client who, earlier this year, withdrew funds from her Roth IRA to buy a house while her current home was under contract to sell. When the buyer backed out at the last minute, she missed the 60-day cutoff.

To mitigate some of that risk, advise clients to tap Roth IRAs before traditional IRAs. This way, if they do fail to replenish their account, the tax bill won’t be quite as hefty as if they tapped out a traditional IRA.

Clients can withdraw a sum equal to what they contributed tax free and penalty free. It is only if they dip into the Roth IRA’s earnings that they could owe taxes and penalties.

“This is the preferable option since the principal is yours and only the growth is taxed,” says advisor Dennis Nolte, vice president of Seacoast Investment Services in Winter Park, Florida.

Clients over age 59 1/2 won’t face the additional tax penalty younger people do if they cannot return the money to the account, which makes this kind of borrowing a safer move for them. And if they withdraw from a Roth IRA they have had open for at least five years, they can take any money out tax and penalty free.

First-time homebuyers or homebuyers who haven’t owned a principal residence during the past two years also enjoy an extra perk that may help them return the funds. These clients, if they’re under 59 1/2, can take up to $10,000 of Roth IRA earnings or $10,000 from a traditional IRA penalty free to purchase property, and they have an extended window to replenish any money they do remove from their IRAs. (In the case of the Roth IRA, withdrawing the earnings is also tax free, as long as the client has had the account for at least five years. In the case of the traditional IRA, there’s no early-withdrawal penalty, but the withdrawal is taxable.)

“Because homebuying is typically a more drawn-out process, you have 120 days from the day the money is distributed to use it, or if the purchase falls through or is delayed, you can put it back into the account within 120 days,” says Kelley Long, a CPA and financial planner with Financial Finesse.

The doubling of the usual rollover deadline gives clients extra breathing room if they are waiting on the sale of a non-primary property or other asset.

Tell clients who do opt to dip into their account to be mindful of their IRA administrator. Sometimes the financial institution will automatically withhold income tax on the distribution, Long says. It’s not an ideal situation, especially if the client intends to replace the money and thus owe zero taxes.

“I advise them to not withhold taxes for the distribution because if they do, they will have to make up the difference when they put the money back in,” says advisor Monica Dwyer with Harvest Financial Advisors in West Chester, Ohio.

For instance, a client in the 25% tax bracket, who needs $100,000 to spend would actually withdraw about $133,000, if they or their financial institution wanted to cover the federal tax bill that would be due if they didn’t return the sum in 60 days. This creates a big problem for clients as they’re essentially borrowing more than they actually need, adding more than $33,000 to the amount they must replace within that two month period, says Dwyer. And prepaying those taxes means they won’t get that money back until tax time.

Long adds that in every situation it makes sense for the client to borrow just what they need and deal with the tax bill only after they’ve missed the window to replace the money. This is especially true for clients who typically receive a tax refund. Whatever they owe may already be offset by that sum.

And, if the client did miss the deadline because they were waiting for a cash inflow or home sale that came past the 60-day or 120-day window, they may now have the funds on hand to handle the bill.

Every advisor did also emphasize one other key point: If you can be creative and find another solution for your client, do so. Tapping a retirement account should, in most cases, be a last resort.

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