By Ian Berger, JD
Who can offer them? Most company retirement savings plans, such as 401(k), 403(b) and 457(b) plans, are allowed to (but not required to) offer plan loans. Loans are not allowed from IRAs or SEP and SIMPLE-IRA plans.
What is the maximum amount I can borrow? Plan loans are generally limited to the lesser of 50% of your vested account balance, or $50,000. Your employer can allow an exception to this rule: If 50% of your vested account balance is less than $10,000, you can still borrow up to $10,000.
Example 1: Justin participates in a 401(k) plan that allows plan loans. Justin’s vested account balance is $16,000. If his plan doesn’t allow the exception, the most Justin can borrow is $8,000. If the plan allows the exception, he can borrow up to $10,000.
Can I have more than one loan at a time? Yes, but any new loan, when aggregated with the outstanding balance of the existing loan, can’t exceed the plan’s maximum limit.
How long do I have to repay the loan? Generally, you must repay a plan loan within 5 years. But a loan used to purchase your principal residence can have a longer repayment.
How are loan repayments made? Loans must be repaid in substantially equal amounts made at least quarterly. Most plans require repayment through payroll deduction.
What are some advantages of taking a plan loan?
· Plan loans don’t require a credit check, and the application process is simple and quick.
· As long as the loan satisfies the above rules, it isn’t a taxable distribution.
· Plan loans usually offer better interest rates than commercial loans. Also, repayments are made back to your account – not to a bank.
What are some disadvantages of taking a plan loan?
· By borrowing against your account, you are reducing the tax-deferred savings that you may need for retirement.
· If your loan violates one of the plan loan rules, your entire outstanding balance will be taxable income to you and can’t be rolled over.
· If you terminate employment with an outstanding loan balance and can’t pay off your balance, your account will be offset by the loan balance. That balance is considered a distribution subject to tax and penalty. You can avoid the tax hit if you can come up with the funds to roll over the unpaid balance to an IRA. The rollover deadline is April 15 of the year following the year the offset occurs (or October 15 if you file for a tax return extension).
Example 2: Elena, age 45, terminates employment on February 15, 2020 with a $50,000 401(k) account balance and a $20,000 loan balance. Elena does not have the funds to repay the loan balance. On March 10, 2020, the plan offsets her $50,000 account balance by the $20,000 loan balance and distributes $30,000 to her. Elena has until April 15, 2021 (or October 15, 2021 if she files for an extension of her 2020 tax return) to find other sources to replace the full $20,000 so she can complete a full rollover. Otherwise, she would owe taxes on the $20,000 and a 10% early withdrawal penalty of $2,000.