Tuesday, February 9, 2010

Tax-Free No-Interest Loan from an IRA?

Q I heard that I can borrow money from my IRA without paying any tax on the money I withdraw. Is this true?

A The answer is a qualified ‘yes’, but be very careful. Here’s how it works:

Generally, the entire amount distributed from an IRA (or other qualified trust or eligible retirement plan) must be deposited in another such account within 60 days. If you withdraw money from an IRA and ‘roll it over’ into another IRA within 60 days, there are no adverse tax consequences.

So, that could be considered a no-interest, short-term loan.

However, if you fail to deposit all of the funds into the new IRA within 60 days, the entire amount is included in your gross income. Plus, you may be subject to the 10% early withdrawal penalty.

The IRS typically is not forgiving about this deadline. A good-faith misunderstanding between the taxpayer and the financial institution usually has been grounds for a waiver if the taxpayer clearly did not intend that funds be withdrawn from an IRA or gave instructions that were intended to complete a timely rollover. Other administrative mistakes by the financial institution can also be grounds for waiving penalties.

However, the tax literature is full of seemingly reasonable excuses the IRS did not go along with. For example, a taxpayer was two days late rolling over an IRA because his spouse was admitted to the hospital for emergency surgery on day 58. The IRS refused to waive the penalty or allow for a late rollover.

So, if you intend to use an IRA withdrawal as a short-term loan, be sure to deposit the money into another IRA within 60 days.