Featured Article – Lending to yourself with an IRA?

Published on October 13, 2011

Diagram Business Chart Data Analyzing Howard M. Phillips is a fellow of the Society of Actuaries and the Conference of Consulting Actuaries, a member of the Academy of Actuaries and the American Society of Pension Professionals and Actuaries, and an enrolled actuary. He is past president of Consulting Actuaries Incorporated in Fairfield NJ and past president of The American Society of Pension Professionals and Actuaries. He is an independent consulting actuary with offices in Fairfield, NJ and Delray Beach, FL.

Self-directed IRAs make available to IRA owners several types of investments not otherwise available in a traditional IRA:

However, an important self-directed investment, a loan to yourself, is not available yet in the law.

Loans to yourself have been available in most retirement plans for many years. “Most” not “all” because IRAs are excluded as are some Section 457 Plans.

The positive value of Loans in retirement plans is described well by a Nobel Prize winning economist and more recently by two economists in a paper prepared for the Federal Reserve:

From Professor Franco Modigliani, 1985 Nobel Prize winner:

“One of the most valuable and attractive options that the 401(k) (type) programs(s) has sanctioned is that of permitting plan sponsors to allow 401(k) and 403(b) participants to invest a portion of their capital in a temporary loan to themselves. This facility has the effect of increasing the liquidity of the capital accumulated in the account, making the accumulation much more affordable and attractive, especially for young people and people of more limited income, who tend to have little by way of reserves and therefore cannot afford to stash money away in a form where it becomes inaccessible for decades, no matter how great the need. In addition, the 401(k)/403(b) self-loans provide a source of credit that is not only available but also generally cheaper than available alternatives, especially for younger and poorer people.”

A mid-2009 research paper published by the Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington D.C., authored by Fed economists Geng Li and Paul A. Smith, concludes that there is significant positive value available from participant loans in retirement plans.

“. . . we find that many loan-eligible households carry relatively expensive consumer debt that could be more economically financed via 401(k) borrowing.”

All of the reasons given to support having personal loans in qualified retirement plans are equally applicable to IRAs.

The key reason [for the IRS] to consider personal loans now for IRAs is the current initiative to require that employers (with a very small employer exception) provide for a payroll deduct IRA for employees where that employer does not sponsor another retirement plan. Since the initiative includes the provision that an employee can decline participation, allowing for a personal loan will give all employees the comfort in knowing they have access to a tax-free loan should such a pre-retirement need occur. Several noteworthy studies have shown that plans allowing for personal loans have significantly greater retirement savings participation and contribution amounts than plans that do not allow for loans.

Section 72(p) and its regulations should become applicable to all non-Roth IRAs (payroll deduct IRAs, non-payroll deduct IRAs, rollover IRAs, SEP-IRAs). One consideration for this applicability could be a modification in the $50,000 limit in Section 72(p). Perhaps that limit should be reduced for non-rollover IRAs to $15,000 (bearing a similar relationship to the $50,000 limit as does the contribution limit-IRA vs. 401(k)).

Bullseye in Dollar SignThe burden of loan initiation, processing and administration will not be placed upon employers, or IRA custodians. This is so because there are available today fully automated systems for loan initiation, processing and administration of Section 72(p) loans.

Those involved in bringing payroll deduct IRAs to Congress for legislative enactment are urged to consider this modification in the proposed bill so as to lessen significantly the number of employees who will reject participation, and will allow other IRA holders to have an access to funds in an emergency, such that that retirement account will be restored by repayments (rather than having to withdraw, suffer the tax, without repayment, in order to handle the financial need).

In December 2010, the Investment Company Institute published “The Role of IRAs in U.S. Households’ Saving for Retirement.” Here are the highlights of the findings:

  1. 4 out of 10 U.S. Households owned IRAs in 2010.
  2. Although most U.S. households were eligible to make contributions, few did so.
  3. IRA withdrawals are mostly retirement related.
  4. 64% of IRA owners indicated a possible future need for the monies to cover emergencies.

What does this mean?

  1. A mandated employer sponsored payroll deducted IRA program, with an opt out, will have little participation.
  2. IRA owners avoid pre-retirement withdrawals because of the tax and penalties involved.
  3. Many may be forced to lose retirement savings to tax and penalties should an emergency arise.
  4. Allowing for a tax-free personal loan from an IRA would significantly change the published results in connection with numbers of households contributing, would satisfy those indicating a possible future need in an emergency, and would allow those maintaining high interest cost revolving lines of credit with credit card companies to shift credit card borrowing costs to retirement savings (interest payable to one’s own account).

DISCLAIMER: Next Generation Trust Services, LLC does not endorse any products, services or investments that may be involved in this article, and this has been posted solely in an educational manner. Readers are encouraged to do their own due diligence regarding any investments or companies mentioned in this article.