Retirement accounts, such as a 401k or IRA, are great tools for building your savings quickly. You may think that you can use that money whenever you want and for whatever you want. After all, it is your money right? However, while it’s tempting to borrow from your future self for immediate wants and/or needs, there are restrictions on what you can and can’t actually use IRA funds for. The four main prohibited IRA transactions are explained below.
- Borrowing money. This may be the most frustrating of all restrictions to some people who could really use the money during a rough financial patch, but an IRA isn’t the most ideal account to borrow from. First, taking distributions before age 59 ½ will incur a 10% penalty and the claimed income from a traditional IRA distribution could bump you to a higher tax bracket. Second, you most likely won’t be able to replace all of the borrowed funds at a later date since IRAs are subject to a $5,500 per year contribution cap. If you take into account compounded interest, a small loan to yourself from your IRA can end up costing you much more in the long run.
There are a few exceptions to the early distribution penalty, such as a first-time home purchase or paying for college tuition, but these are still advised against due to the lost compounding interest potential. While you can use funds to make investments, the direct beneficiary to your investment must be a qualified person. For instance, you can’t invest in a business you or your spouse started because that would be considered borrowing funds for your own benefit.
- Selling property to the plan. If you own property, you can’t use IRA money to purchase it from yourself. For instance, you can’t “sell” your house to your IRA to essentially pay off the owed mortgage. This would be considered doing business with yourself and personally gaining from this type of transaction, therefore it is not allowed.
- Using the account for loan security. Most loans require some sort of collateral to ensure that you can pay back the loan somehow. However, IRAs cannot be used for this purpose. Any amount you claim as collateral will be treated as a distribution and will be subject to early distribution fees and income taxes (if from a traditional IRA).
- Buying property for personal use. Any property you stand to personally gain from, whether you live there or not, cannot be purchased with IRA money. This would include your own living arrangements, a property you intend to rent out, a property you intend to conduct business on, or any other property that would directly benefit you in some way. While you can invest in real estate with an IRA, you can’t be directly involved with any maintenance or decision making regarding said property. These two categories are considered “sweat equity”, which would end up directly benefitting your IRA and therefore are prohibited.
The penalty for committing any one of these prohibited transactions can be severe depending on the amount of funds used in these ways. The funds you use from your IRA will be considered a distribution that you may have to pay a penalty and/or taxes on. The moment you use retirement money for non-retirement use, it ceases to profit from the benefits IRAs offer. Think twice the next time you’re tempted to use IRA money for personal use before retirement, and remember to always stay up-to-date on IRA rules, regulations, and restrictions.