How to Take IRA and 401(k) Loans (And Why You Shouldn’t)

I’m going to start this primer on IRA and 401(k) loans with a simple piece of advice: If at all possible, don’t take any IRA or 401(k) loans.

The money you deposit in qualified retirement accounts is protected from taxation for a simple reason: It’s for your retirement, not for tax-free discretionary spending.

The IRS does not look kindly on people who use their 401(k) or IRA as a short-term tax shelter. That’s why it hits unqualified early withdrawals with a 10% tax penalty in addition to your normal income tax rate.

That being said, life is unpredictable. Sometimes emergencies or unforeseen personal circumstances arise that might force you to dip into your 401(k) or IRA.

The IRS recognizes this, and it does permit you to take certain types of loans or early withdrawals from your retirement accounts without penalty, provided that you strictly follow all the rules around them.     

Today, we’re taking a look at all the penalty-free ways a pre-retiree can access some of their 401(k) or IRA balance as a last-resort source of funds.

401(k) Loans

Some — but not all — employer-sponsored 401(k) and 403(b) plans allow you to borrow from your own account without a tax penalty. Check with your employer to see if your plan offers loans, and take note that you cannot borrow from an old 401(k) from a previous employer.

401(k) loans typically must be paid back within five years. Many come with some kind of administration or origination fee, and most require you to pay your account back with interest.

Many 401(k) loan programs allow you to pay back the loan with paycheck deductions, making the process fairly easy.

It’s worth mentioning, however, that 401(k) loan repayments are made with after-tax dollars regardless of the account type. That means if you’re paying back a loan from a traditional 401(k), your money is effectively being taxed twice — once when you pay it back, and then again when you withdraw it during retirement.

If you fail to repay the loan on time or if you leave your job with an outstanding loan, then the loan will be reclassified as an unqualified withdrawal, and you’ll be hit with tax penalties.

IRA “Loans” and the 60-Day Rollover Rule

Technically speaking, IRAs don’t offer loans.

In practice, however, there is a way to borrow from them, but it’s much shorter term and less user-friendly than a formal 401(k) loan program.

The IRS allows you to withdraw money from an IRA without tax penalties, fees, or interest, as long as you deposit it back into a qualified retirement account within 60 days.

This provision is intended to help people complete rollovers from one account to another, but it can also be used as an unofficial 60-day loan.

You’re only allowed one IRA rollover per year, and if you fail to re-deposit your IRA money into a retirement account within 60 days, you’ll face tax penalties.  

Roth IRA Principal Withdrawals

Roth IRA contributions are made with after-tax dollars.

That means the principal in a Roth IRA (i.e., the money you’ve contributed, not your investment profits) is yours to spend as you like. You can withdraw it without incurring any additional taxes or fees.

This is not really a loan; it’s a penalty-free withdrawal. However, in a way, you’re still penalizing yourself by using this method. Principal dollars you withdraw from a Roth IRA aren’t compounding tax-free like they would if you left them in the account.

Substantially Equal Periodic Payment (SEPP) Plans

Setting up a substantially equal periodic payment (SEPP) plan is the most obscure and poorly understood way to access funds in a retirement account before retirement age. And there’s a good reason it’s not often discussed — a SEPP is the most drastic and irreversible way to make an early withdrawal.

A SEPP plan allows you to collect all the money in your IRA or employer-sponsored account in yearly distributions for five years or until you reach age 59.5 — whichever one is longer. In other words, it forces you to withdraw your whole balance before you retire.

The IRS allows SEPP plan participants to choose one of three methods for calculating yearly distributions. The required minimum distribution method involves annual payments of varying sizes based on account balance and life expectancy, while the fixed amortization and fixed annuitization methods involve fixed payments.   

SEPP plans are only available for IRAs or old 401(k)s or 403(b)s; they cannot be set up for an account sponsored by your current employer.

And like the other loan and withdrawal strategies discussed here, SEPP plans can land you heavy tax penalties if you misuse them. Withdrawing a larger or smaller yearly amount than is permitted by the plan parameters reclassifies the SEPP plan as an unqualified withdrawal and incurs a 10% penalty plus income tax.   

Why You Shouldn’t Take an IRA or 401(k) Loan Unless You Really, Really Have To

Here at Wealth Daily, we focus on helping people save and invest for retirement.

In other words, we firmly believe pre-retirees are better off putting money into their 401(k) or IRA rather than taking money out of it.

After all, these methods — even if you use them correctly and avoid tax penalties — carry substantial opportunity costs.

Borrowing or withdrawing money from a retirement account means not letting it grow in the market, and many borrowers stop making additional contributions to their accounts while they pay back their loans. These two factors can shave tens of thousands of dollars off your balance by the time you hit retirement age.

IRA and 401(k) loans should only be used in desperate times. Credit cards and even personal loans are less risky ways to borrow money. But if you find yourself with your back against the wall and unable to access other sources of funding, you now know how to use your retirement accounts to bail yourself out.

Until next time,

Samuel Taube

Samuel Taube brings years of experience researching ETFs, cryptocurrencies, muni bonds, value stocks, and more to Wealth Daily. He has been writing for investment newsletters since 2013 and has penned articles accurately predicting financial market reactions to Brexit, the election of Donald Trump, and more. Samuel holds a degree in economics from the University of Maryland, and his investment approach focuses on finding undervalued assets at every point in the business cycle and then reaping big returns when they recover. To learn more about Samuel, click here.