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Tuesday, March 5, 2024

The 60-day rollover rule for borrowing from your retirement plans

The 60-day rollover rule allows you to borrow money from your retirement plans tax-free and penalty-free. You can use the rule once a year.

In general, though, I am don’t think it’s wise to borrow from your retirement plans. If you do, you could be making a habit of robbing your retirement future. You may also have to pay a penalty and taxes for early withdrawal.

Let’s explore what seems like a loophole. I say loophole because the IRS technically doesn’t allow you to borrow money or take out a loan from any type of IRA unless you meet some specific requirements.

Penalty-free IRA withdrawals

Before we get into the nitty gritty of the 60-day rollover rule, let’s look at the following situations that allow penalty-free withdrawals from your IRA:

  • Incompetence
  • Qualified higher education expenses
  • First-time home buyers up to $10,000
  • Series of equal payments
  • Unreimbursed medical costs
  • Benefits to qualified military reservists called to active duty

If you don’t qualify for one of these penalty-free IRA withdrawal situations, this is where the 60-day rollover rule comes in handy.

The 60-day rule to borrow from pension schemes without penalty

The IRS allows tax- and penalty-free rollovers from one tax-advantaged retirement plan or account to another if you follow the 60-day rule.

The 60-day rollover rule requires that you deposit all of your money into a new individual retirement account (IRA), 401(k), or other qualified retirement account within 60 days of the distribution. You also have the option to use money from your account and pay it back within this period.

If you do not meet the 60-day deadline, your pension funds will be subject to income tax. And if you’re under 59½, a 10% early withdrawal penalty also applies.

The 60-day rollover rule is actually very common as people change jobs. Let’s say you leave your job of five years with a 401(k) plan. You can choose to leave your 401(k) plan as it is at the company, or what most people do convert their 401(k) into an IRA.

An IRA generally has more flexibility, fewer costs and more investment choices for the retirement saver. I converted my 401(k) to an IRA in 2012. And if I ever get a new job, I’ll just start contributing to a new 401(k).

If you decide to convert your 401(k) into an IRA, you essentially have 60 days to do so penalty- and tax-free.

You can do anything with the borrowed money

Let’s say you have $1 million in your IRA. Thanks to the 60-day rollover rule, you could technically sell all your investments and spend a week gambling and partying in Vegas. You could even bet $1 million on black and end up winning $2 million!

As long as you return the $1 million you withdrew within 60 days, you won’t pay any penalties or taxes. In this scenario you even have €1 million gross left over! Ah, do you see how easy it is to get rich?

Just kidding. Do not do this. You will probably end up bankrupt and in debt.

The 60-day rollover rule is not necessary for direct rollovers

One time I transferred directly from my Fidelity account to my Citibank account. I did this because I wanted to increase my holdings at Citibank relationship prices for a refinancing with a lower mortgage interest rate. Otherwise, I would have just converted my Fidelity 401(k) to a Fidelity IRA because the platform is better.

The reality is that most rollovers are done electronically with a direct rollover. The process usually takes less than ten days. Therefore, having 60 days to renew your retirement plan is somewhat excessive.

If you don’t want to do a direct electronic rollover, you can receive a check made out to the new 401(k) or IRA account. You then send the check to your new employer’s plan administrator at the financial institution that has custody of your IRA. If you’re starting your own business, you can deposit the check yourself.

A physical check is fine. But there is a risk that it will be lost or stolen in the mail. As such, having 60 days to roll over a retirement plan is a nice cushion in case something goes wrong.

With a direct rollover, at worst, you can deny that you never actually received a taxable distribution if the money is not deposited within 60 days.

The 60-day rule mainly applies to indirect rollovers

With the indirect rollover, you take control of the money and can transfer the money yourself to a retirement account. You can make an indirect rollover with all or part of the money in your account.

This is where you can borrow money from your retirement plan tax and penalty free during the 60 day period.

The plan administrator or account custodian liquidates some or all of your assets. They will send you a check in the mail or deposit the money directly into your personal bank/brokerage account.

You have 60 days after receiving an IRA or retirement plan distribution to rollover or transfer it to another plan or IRA. If you don’t roll over your money, you may have to pay a 10% early withdrawal penalty and income taxes on the withdrawal amount if you are under age 59½.

How taxes work when borrowing money from your retirement plan

Let’s say you borrow $100,000 through your indirect rollover. When your 401(k) plan administrator or your IRA custodian writes you a check or electronically deposits the money into your checking account, by law they must automatically withhold a certain amount of taxes, usually 20% of the total. So you will receive less than the amount that was in your account.

In this case you will receive €80,000 and €20,000 will be withheld. So if you actually need $100,000 to go to Vegas, you might need to borrow $125,000 to get $100,000 net.

Let’s say you borrow $100,000 from your IRA and receive $80,000 net. You must repay the €80,000 within 60 days to avoid penalties and taxes. If your 401(k) custodian or your IRA custodian sends you the full $100,000, you must pay back the $100,000 within 60 days to meet the 60-day rollover rule.

However, if you fail to return 100 percent of the proceeds, the difference is taxable and subject to the additional 10 percent penalty if you are under age 59½.

Also consider withdrawal fees from the IRA custodian. Before you back out, ask first.

Borrow money from an IRA WITHOUT flipping it

Here’s another loophole when borrowing money from an IRA or 401(k). It doesn’t seem like you need to actually convert your 401(k) or IRA into another plan to borrow money.

I spoke to my wealth advisor, who said I can simply borrow money from my IRA tax-free and penalty-free, as long as I pay back 100% of the money within 60 days. When I do that, it’s like nothing ever happened.

I’ve looked everywhere online and don’t see any literature saying this isn’t possible. If you are from the IRS or a CPA and understand the 60-day rollover rule, feel free to participate.

Borrow money from an IRA to buy a house

The main reason why I wrote this post is because I need extra money to buy a house. I have learned that selling individual municipal bonds is expensive, so I started looking for other sources of capital. Since I’m also not a first-time homebuyer, I didn’t qualify for a $10,000 penalty-free IRA withdrawal.

In my IRA, I have $118,786.80 in Treasury bonds maturing on November 15, 2023. Since Treasury bonds are liquid, I should be able to get very close to market value at the time of sale.

Alternatively, selling ~$118,786.80 in municipal bonds would cost me about 2.85%, or $3,385 to sell. Besides, I would be giving up the benefit if I kept them until adulthood. So by instead selling one $118,786.80 government bond position in my IRA, I can save at least $3,000.

I normally don’t recommend borrowing from an IRA to buy a house using the 60-day rollover rule. In this case, however, my government bond will soon mature. I’ll have to figure out how to reinvest it. An obvious way is to reinvest the government bond position in a house that I don’t have enough money to buy.

The biggest challenge is returning the borrowed money to the IRA

If I continue with the withdrawal, the challenge will raise $118,786.80 within 60 days to avoid paying a 10% penalty and taxes. As far as I know, no one is going to give me a job that requires me to make $100,000 a month before taxes so I can return 100% of the money within 60 days.

If I don’t pay back 100% of the money, I will have to pay a minimum of $11,878.68 in fines. Then I would have to pay income tax on the profits on government bonds.

Therefore, be careful when withdrawing funds using the 60-day rollover rule. If you sell a highly appreciated asset and don’t pay back 100% of the money, the tax liability and penalty can be overwhelming.

Stay disciplined with your retirement funds

Also important is what you are withdrawing money for. If you’re going to use the 60-day rule to pay for a medical procedure that will save your son’s life, then do it. With no other financial options, you must first save your son’s life and later figure out how to get the money.

If you want to withdraw IRA money for something else, you may have to leave your money alone. Your retirement plans are for your retirement, not for current consumption.

Frequently Asked Questions – FAQs

Can I borrow from my retirement plans without penalties?

Yes, using the 60-day rollover rule allows tax-free and penalty-free borrowing once a year.

What are the risks if I fail to meet the 60-day rollover deadline?

Failure to meet the deadline results in income tax and a 10% early withdrawal penalty for those under 59½.

Can I use the 60-day rule for direct rollovers?

Direct rollovers are typically done electronically, minimizing the need for the 60-day rule.

How does the 60-day rule apply to indirect rollovers?

Indirect rollovers involve taking control of the money and transferring it to another retirement account within 60 days.

What happens if I borrow money from my IRA and fail to repay 100% within 60 days?

Failure to repay 100% results in taxable differences subject to a 10% penalty if under age 59½.

Is it possible to borrow money from an IRA without converting it to another plan?

Yes, a loophole allows borrowing from an IRA without conversion, as long as 100% is repaid within 60 days.

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