Can Retirement Accounts Be Used As Collateral?
Retirement plans can build up a large amount of cash, particularly if you begin investing early in your career. To leave the money in the account and allow it to grow -- and because tax laws may not allow you to take a withdrawal without taxes and penalties -- you may want to take out a loan, using your retirement account as collateral. This isn't always possible, and it could cause you to lose the tax benefits of the retirement account.
A 401(k) account is held in your employer's name on your behalf, unlike an individual retirement account, which is held in your name. Therefore, you don't have the same access to a 401(k) account as you do with an IRA. Your employer's plan controls whether you can take out money, and many only allow early withdrawals for a financial hardship. Because you can't tap your 401(k) whenever you choose, using your account as collateral for a loan is difficult, since the lender can't withdraw the money to pay off the loan if you default. This is because 401(k) accounts are protected from creditors by the Employee Retirement Income Security Act.
Your 401(k) plan may allow you to borrow money. Some plans only allow you to do this for certain reasons or if you face a hardship. As of 2013, the Internal Revenue Service allows you to borrow up to 50 percent of your account's value or $50,000, whichever is lower. You pay back the loan with interest. If you leave your job before doing so, the outstanding amount is usually due in 60 days. If you can't pay back the loan in that time frame, the loan balance becomes an early distribution and is subject to regular income taxes and a 10 percent early withdrawal penalty if you are under age 59 1/2.
The IRS doesn't allow you to use an IRA as collateral for a loan. IRS Publication 590 classifies this as a "prohibited transaction," along with things like buying property for personal benefit. You can't get around the ban by borrowing directly from the IRA -- that is also a prohibited transaction.
If you use an IRA as collateral for a loan, the IRS considers the entire value of your account a distribution. You will lose all of the tax-advantaged benefits of the account, including the ability to make additional contributions. Your entire account balance will also be considered income in the year you used the IRA and will be taxed at your regular rate. If you are under 59 1/2, you will need to pay the 10 percent early withdrawal penalty.
Craig Woodman began writing professionally in 2007. Woodman's articles have been published in "Professional Distributor" magazine and in various online publications. He has written extensively on automotive issues, business, personal finance and recreational vehicles. Woodman is pursuing a Bachelor of Science in finance through online education.