From time to time clients ask, “How can I use my IRA to help my children or others? Can I use my IRA to loan money to my children to buy a home or start a business?”
Unfortunately, the short answer is that you can’t loan money from your IRA to your children for the purchase of a home or to start a business. More accurately, you can’t do it without severe tax consequences, because any money you lend to a lineal family member is considered a withdrawal by you, and you will be taxed on it.
It can be frustrating to owners of large IRAs not to be able to use their IRAs how they want. But in exchange for the tax benefits of IRAs, you have to follow the rules. Given the depressed real estate markets, some believe that this is a good time to buy real estate (see Mark Stinson’s article in the Planning section of this newsletter).
Let’s look at the IRA rules in more detail and see whether it makes sense to use IRA loans to family members to purchase real estate.
Who are lineal descendants?
IRA rules distinguish between “lineal descendants,” who are not eligible for non-taxable loans, and “non-lineal descendants,” who can be given non-taxable loans. Examples of lineal descendants include (and may not be limited to): spouses, parents, children, and grandchildren. This list pretty much rules out non-taxable loans from your IRA to your family.
Notice that the list does not include brothers, sisters (including in-laws), and friends. You can make loans to them from your IRA, tax-free, under some circumstances.
Here are the types of loans that are permitted from your IRA:
- Loans to brothers and sisters, including in-laws
- Loans to non-family members who are not employed in your business
- Loans secured by the purchase of rental real estate property (this is best done from a Roth IRA).
Specific loans and other activities that are not permitted from your IRA include:
- Using your retirement plan to buy a home for you to live in now
- Pledging assets of your retirement as collateral for a loan
- Selling personal investment property to your IRA
- Buying collectibles such as rugs or gems
- Loaning money to your child
- Owning/purchasing stock in an S Corporation
- Paying yourself fees from cash flow (i.e., rental income) derived from your plan’s investments
- Purchasing life insurance with IRA funds.
Why is a Roth IRA the preferred vehicle for purchasing a rental property?
Owners of Roth IRAs might consider using them for a loan. Here’s why. First, we assume that you want to eventually move into and live in the real estate you are purchasing in the Roth IRA, but you are renting it to tenants now. In order for you to convert the rental activity to personal use, you distribute the rental property from the Roth IRA to yourself. Because you’re distributing from a Roth IRA, you pay no tax. (Remember that distributions from a Roth IRA are not taxable.) You are then free to move into the real estate property and use it as your personal residence.
How should you set up your IRA to lend money tax free?
You will need to set up a “self-directed” IRA. There are only a few nationwide vendors who provide the necessary custody services. The fees they charge are much higher than you would pay for a traditional IRA. Our preferred custodian, TD Ameritrade, does not offer self-directed IRAs. If you would like more information about these types of IRAs, please call your BWFA advisor.
IRAs are intended to be used for your retirement. For the most part, laws prevent owners of such accounts from investing in collectibles, making loans to family members, and supporting their own businesses. If you want to use your IRA for a purpose other than saving for retirement, talk to us about the financial and tax consequences.