Internal Revenue Service rules are very clear: you cannot use your Roth individual retirement account as collateral on a loan. Should you do so, the portion of the account you put up as collateral is considered a distribution, in which case it ceases to be a Roth IRA asset.
What Are the Prohibited Transactions?
Using your Roth IRA as collateral on a loan is on the IRS' list of prohibited transactions – activities you must not engage in if your IRA is to remain an IRA. Prohibited transactions also include borrowing money from your IRA or selling goods and services to it.
You can't use your IRA to purchase something for your own use; for example, if you purchase a vacation property with IRA funds, you can rent it out, but never stay there yourself. Finally, you cannot pay yourself an inordinate amount of money to manage an asset your IRA owns.
Understand Disqualified Persons
Prohibited transactions apply not only to you, but to what the IRS calls "disqualified persons," as well. Your descendants (children and grandchildren), your ancestors (parents and grandparents) and their spouses are disqualified. Fiduciaries are also barred from making prohibited transactions.
Fiduciaries are people responsible for managing your IRA or advising you on how to manage it. They also include parties who are involved with administering your account, i.e., buying and selling assets and collecting asset earnings.
What Are the Tax Consequences?
The moment you pledge all or a portion of your Roth IRA as collateral, the IRS says you have taken a distribution from your account. If your account has been open at least five years and you are 59 1/2, you do not owe taxes on the amount; however, you miss out on possible tax-free earnings that portion of your distribution may have earned. If you are not yet 59 1/2, or you are but your account has not yet been open five years, you owe a 10 percent penalty on amounts you withdraw that exceed your total Roth IRA contributions.
What's the Significance?
Prohibited transactions are intended to prevent you from benefiting twice from your IRA. Your Roth IRA provides you with a powerful tax incentive to save for retirement: you can accumulate tax-free earnings on your investments that are available to you beginning the year you turn 59 1/2.
In the meantime, the IRS does not want you to use your tax-sheltered assets to enrich yourself or your family. Furthermore, putting your Roth IRA up for collateral would mean risking retirement income, which the government does not want to encourage.
Exploiting a Loophole
There is one special circumstance which you can exploit what we call the 60-day rollover role and use your self-directed IRA as a collateral for a short-term loan. However, you must meet certain criteria to qualify.
By exploiting this loophole, you can withdraw money from your IRS account and redeposit it in the same IRA or a different one within 60 days or less. You can then use the money as a short-term loan and replace it once you get the funds.
There are serious consequences if you fail to adhere to the 60-day rollover rule. For one, the funds will be subjected to income tax. And two, you’ll incur a 10 percent early withdrawal penalty if you’ve not attained the age of 59 1/2 and above.
Alternatives to Borrowing Using Your Roth IRA
There are a few other options if you’re in a tight spot financially. Here are a few:
Taking Out Unsecured Loans
To ensure you don’t sabotage your retirement funds, it can help to source for a loan elsewhere. An unsecured loan may be just what you’re looking for. There are many sources to get an unsecured loan such as from friends, a family member or credit unions.
Borrow Money Against Workplace Retirement Plans
You can borrow money against retirement plans such as a 401(k). However, not all retirement plans can be used as a collateral for a loan. It’s important to note that there are consequences to taking a loan against a workplace retirement plan. One, you’re reducing your savings and potential interest. You’ll also incur tax penalties for late payment or failure to pay the loan.
Diane Kuriluk has been writing about small business solutions, economics and personal finance since 2007 for sites that include Work.com. She is also a professional grant writer for nonprofit organizations. She attended the University of Michigan.