Retirement plan loans as a source of ready cash—the pros and cons
Although it is generally not considered prudent to withdraw funds from a retirement savings account until retirement, sometimes it may appear that life leaves no other option. However, borrowing from certain qualified retirement savings account rather than taking an outright distribution might prove the best solution to getting you through a difficult period. If borrowing from a 401(k) plan or other retirement savings plan becomes necessary, for example to pay emergency medical expenses or for a replacement vehicle essential to getting to work, you should be aware that there is a right way and a number of wrong ways to go about it.
When a plan loan is not a taxable distribution
In general, a loan from a qualified employer plan, such as a 401(a) or 401(k) account, must be treated as a taxable distribution unless you can meet certain requirements with respect to amount, repayment period, and repayment method.
First, however, the terms of the employer-plan must allow for plan loans. Due to administrative costs and other considerations, plan loans are made optional for employer plans. If permitted, however, loans must be made available to all employees.
A loan to a participant or beneficiary is generally not treated as a taxable distribution if:
The loan is evidenced by a legally enforceable written agreement that specifies the amount and term of the loan and the repayment schedule;
The amount of the loan does not exceed $50,000 or half of the participant's vested accrued benefit under the plan (whichever is less);
The loan, by its terms, requires repayment within five years, except for certain home loans; and
The loan is amortized in level installments over the term of the loan.
Plan loans may be made only from employer-based plans. Individual retirement accounts (IRAs) cannot be used as collateral for a loan, nor can a direct loan be made from the IRA to the account holder.
Calculating the amount of the plan loan
In addition to the $50,000 or 50-percent vested benefit rule, several other provisions apply to the amount of the plan loan. First, a plan participant may take out a loan of up to $10,000, even if that $10,000 is more than one-half of the present value of his vested accrued benefit. Second, if a plan participant decides to take out another plan loan, the new maximum amount of the total plan loans will be determined by the following method:
($50,000 − (highest outstanding loan balance during the preceding 12-month period − outstanding balance on the date of the new loan)) = new plan loan maximum.
That new plan maximum must be reduced further by any outstanding loan balance.
Participants must repay a loan within five years. There is one exception, however, for a loan used to make a purchase of a first-time home that is a principal residence. The loan term may then be as long as 30 years.
If a participant defaults on a loan payment, the entire principal may become due under the terms of the plan. In addition, most plan terms require that you repay the loan within 60 days if you leave or lose your job. If you cannot repay at that time, the balance of the loan is usually considered a taxable distribution deducted from your remaining retirement plan account balance. That deemed distribution may also incur a 10 percent early distribution penalty.
Loan repayments must be made at least every quarter, and are generally deducted automatically from a participant’s paycheck. Defaulting on a loan causes the IRS to treat the entire outstanding loan balance as a premature (and therefore a taxable) distribution from the employer plan. A deemed distribution occurs at the time of the failure to pay an installment, but the plan administrator can allow a grace period. The deemed distribution then becomes subject to both income tax and the 10-percent early withdrawal penalty.
There are benefits to borrowing from an employer retirement plan, such as providing a ready-made source of credit and the benefit of returning interest paid back into the plan account rather than into the pockets of a third-party lender. There are also many drawbacks to taking out a plan loan. To learn more, please contact our offices.