There are countless reasons you may need to borrow money from your investment and retirement accounts, from paying off credit card debt to purchasing a home. However, it’s important to borrow this money the right way in order to avoid tax penalties and other costly fines. Here is a guide to the best way to borrow money and keep unwanted costs to a minimum.
Borrowing Against Your Retirement Account
It’s possible to borrow from your 401(k) through a loan. In fact, you’re permitted to borrow up to $50,000 or half of your total 401(k) balance, but whichever one provides you with less money is what you’ll be eligible for. For instance, if you have $200,000, you will only be permitted to borrow $50,000, which is the maximum amount. However, if you have $60,000 in your 401(k), then you’ll only be permitted take out $30,000.
While not all employers allow you to take out a loan against your 401(k), larger employers do. The benefits of this approach is you won’t owe any taxes or penalties related to this borrowing as long as you borrow this money the right way.
Know The Risks Involved
This 401(k) loan must be done the right way. If you depart from your job, your former employer will likely want the money back — and fast. If you can’t pay your old employer back, they will treat your withdrawal like an early distribution. At that point, you’ll be hit with interest and penalties. However, this method is in general an excellent way to borrow money if you need it fast and you’re fairly confident you’ll be staying with your current employer.
At the same time, it’s also important to ensure that you repay your loan on a quarterly basis. It must be repaid in an amortized manner, which includes both the initial principal and subsequent interest. While the interest you pay on this loan goes directly back into your own 401(k), the downside is that this interest is not tax-deductible.
If you make a payment within a 90-day timeframe, you could be hit with taxes and a 10 percent penalty from the IRS. Furthermore, you will in most cases be required to pay back this loan within 5 years, unless you used the loan for a down payment on your house.
Using An IRA Rollover
To put it simply, you are severely restricted in terms of borrowing against your IRA. You can’t use your IRA as collateral on a loan, and you can’t use your IRA to borrow against and you are not permitted to borrow money from your IRA account directly.
However, there is one exception to this general rule, which can provide you with temporary money. Essentially, you can “borrow” money from your IRA account with a rollover, but you need to exercise extreme caution when borrowing money through this method.
Basically, you request a check from your old account and roll it over into the new one. However, you have 60 days to put this money back into a different IRA. If you fail to do this, the IRS will categorize your withdrawal as an early distribution. That means you’ll be hit with tax and a 10 percent penalty if you’re younger than 59 and a half.
Using these methods, you can effectively borrow from your retirement accounts without getting hit with excessive penalties or taxes. However, it’s important to follow the rules and guidelines regarding these borrowing methods to protect your finances and future retirement money.