Posted by Maria T. Hurd, CPA
As the holidays get closer, statistics show that more participants will borrow from their 401(k) plans in an effort to make the season a little bit merrier. This approach of taking from their retirement savings in order to give to others and spread some joy may satisfy a short term need, but participants should understand the terms of their loans and realize that they may be paying for their shopping spree for the next five years. I have outlined a few key points to consider below.
Maximum Loan Amount
The Internal Revenue Service (IRS) plan loan regulations limit the amount of the loan a participant may take to the lesser of 50% of their account balance or $50,000, reduced by the highest outstanding loan balance in the previous twelve months. As a result, a participant’s ability to borrow successively from their 401(k) account can be curtailed by the maximum loan rules. Additionally, many plans limit the number of available plan loans to one loan at a time, and prohibit using a second, larger plan loan to repay the first one.
The IRS requires all loans to be repaid in equal at least quarterly installments not to exceed a five year repayment period, unless the loan is taken to buy a primary residence, in which case the repayment period can be longer. Most loan policies require repayments out of payroll, such that the loan becomes immediately due and payable if the participant terminates employment with the plan sponsor. When taking out a loan, participants need to realize that if their employment ends and they are not able to repay the loan, their loan will be in default.
A participant loan is considered to be in default on the last day of the quarter following the quarter in which repayments stop. A defaulted loan is effectively a distribution of the outstanding loan balance subject to income taxes and a 10 percent penalty if the participant has not reached age 59½. If there is a chance that the participant will not work for the plan sponsor for the entire term of the loan, the participant should understand that there are negative tax implications to defaulting on a plan loan. The participant’s credit, however, will not be affected by a plan loan default.
The interest rate charged for plan loans is often set at the prime rate on the date the loan is issued plus 1%, or some other factor that the plan sponsor deems reasonable as compared to the rates used by commercial lenders. Participants find the concept of paying interest to themselves, as opposed to a third party, appealing, but they cannot forget that they are also taking the money out of the market and they could be forgoing an upswing in the market if they take the loan out when the market is low. Additionally, participants should also consider the benefits of a 0% or low-interest credit card for a short-term cash shortfall that can be repaid within a year without incurring the typical loan fees or any interest.
Deductibility of the Interest
A participant’s ability to deduct the interest depends on the use of the borrowed money, whether the 401(k) or 403(b) deferrals secure the loan, and whether the participant is a key employee.
If the deferral portion of the account balance secures the loan, then the interest is not deductible, even if there is other collateral for the plan loan, such as the employer contribution account balance or a mortgage. Most plans allow loans from the entire vested account balance, including deferrals, so interest on plan loans is rarely deductible. Additionally, key employees cannot deduct interest on a plan loan. Generally, a key employee is an individual who meets any of the following three criteria:
- an officer of the plan sponsor who receives annual compensation above $160,000 for 2012;
- an owner of more than five percent of the plan sponsor, (ownership attribution rules apply);
- an owner of 1 percent of the plan sponsor who receives annual compensation of $160,000 for 2012 (ownership attribution rules apply).
If the participant is not a key employee and the plan loan is secured exclusively by the portion of the account balance attributable to employer contributions and the related earnings, then the participant can deduct the interest:
- as mortgage interest if the borrowed money was spent to acquire or improve the participant’s main or second residence,
- as a business expense if the borrowed money is contributed to a pass-through entity that is an active trade or business for the participant,
- as investment interest expense to the extent there is investment income, if the borrowed money is invested.
To Borrow or Not to Borrow
Plan loans for the appropriate amount of money for the right reasons can be a simple and convenient source of funding, but before you borrow from your retirement funds for short-term, minor needs such as holiday shopping, you should ask yourself whether you really want this holiday season to last for the five-year repayment period.