IRA Churning Scheme

[Snaggletooth]

Sluggo wants to take $10,000 out of his 401k, penalty-free, to use for a first-time home purchase. But wait! The penalty-free arrangement does not exist for a 401k, only a traditional IRA allows this.

O.K. Sluggo opens a conventional IRA with $100, and then does a rollover of $10,000 from his 401k to his IRA. Shortly thereafter, he withdraws $10,000 from his IRA.

What is wrong with this picture?

[FEDUKE404]

Likely OK, perhaps unwise

As you noted, although there is no "penalty," Sluggo is still looking at a $10k cap on the withdrawal and then forking over likely 1/3 of that to the IRS/state.

And this assumes Sluggo meets all of the qualifications for establishing a traditional IRA (I despise Form 8606!) and the "first time" home-buyer scenario.

A Roth might have made more (financial) sense.

Frankly, in today's interest markets, I would search for a $10k loan which would likely cost him far less overall than the taxes he would have to pay on the "IRA" withdrawal.

FE

[Roberts]

Don't you think just maybe he needs the $10k as a down payment to qualify?

[Gary2]

O.K. Sluggo opens a conventional IRA with $100, and then does a rollover of $10,000 from his 401k to his IRA.

And this assumes Sluggo meets all of the qualifications for establishing a traditional IRA (I despise Form 8606!) ....

When doing a rollover, most places will let you create a brand new rollover IRA account without needing that $100 (or $1 or whatever) to set up the account. You don't need to meet any qualifications for this, nor is 8606 required. Indeed, there's a tactical advantage to keeping rollover IRAs (called conduit IRAs in Pub. 590) segregated, because they allow more options if you want to roll them back into an employer plan.

Frankly, in today's interest markets, I would search for a $10k loan which would likely cost him far less overall than the taxes he would have to pay on the "IRA" withdrawal.

That often won't work or isn't advisable. If you're in a situation where you need that extra $10K for a home purchase, you may be near the lending limits. The mortgage lender will want to know if you're borrowing funds for the down payment, and that can affect their lending decision.

The more basic catch to this scenario is that you can't just take funds out of a 401(k) with your current employer. If and when you leave the job, then rolling it over into an IRA (conduit or otherwise) often makes sense, just to give you more control over the investment options and more flexibility. It also helps keep things consolidated, if you tend to bounce between jobs every few years (which is common in high tech).

But a better option with your current employer's 401(k) - if you have confidence in job security (a very big if) - is to take a loan from the 401(k). Most plans will allow this, and since you're borrowing from yourself, it's cost effective. The limit is a percentage of assets, so it can be more than $10K. The catch here is that if you leave the job, then the balance on the loan is treated as a distribution (subject to usual taxes and penalties), unless you pay it back relatively quickly. So it's a bad idea to use this as a general source of funds, nor would I suggest using it as the sole source of a down payment on a home. But in a good economy, it's a reasonable choice for part of the down payment.

By the way, calling this "churning" overstates the tactic. Churning usually means something that gets repeated, while this can't be.