Individuals who participate in a 401(k) plan sometimes borrow from their
plan. While you may justifiably feel squeamish about taking out a 401(k)
plan loan, it can actually make good sense in appropriate
circumstances?assuming it is paid back on time. For instance, in today's
tough economy, plan loans can be a source of much-needed cash when bank
loans are unavailable or prohibitively expensive.
401(k) plan loans are generally economical and easy to obtain. In
particular, a 401(k) plan participant with less-than-stellar credit or
tapped out credit lines may find it much easier and cheaper to borrow from
their 401(k) plan than from a commercial lender.
401(k) plan loans provide participants with access (within limits) to
their 401(k) plan dollars without incurring income tax liabilities and the
10% premature withdrawal penalty tax. The 10% penalty tax generally applies
to withdrawals before age 59 1/2, however, exceptions are available. In
essence, the participant (borrower) pays interest to himself or herself when
taking out a plan loan.
401(k) plan loans are only permitted if the plan document allows them,
and many plans do. The maximum amount that can be borrowed is generally the
lesser of $50,000 or 50% of the participant's (borrower's) vested account
balance. Most 401(k) plan loans are secured exclusively by the participant's
vested account balance (although other forms of security, such as a lien
against the participant's home, are sometimes seen).
At least two major potential pitfalls are associated with 401(k) plan
loans. First, the participant's account balance is irreversibly diminished
if the loan is not paid back. Second, the federal income tax consequences
are harsh for failure to pay back a plan loan according to its terms, and
the loan will usually have to be repaid in full soon after the employee
leaves the job for any reason. Such failure to repay the loan can result in
a deemed distribution of the unpaid loan balance that triggers a federal
income tax hit (possibly a state income tax hit, too). In addition, the
dreaded 10% premature withdrawal penalty will generally apply unless the
participant is age 59 1/2 or older.
Interest paid on a loan secured by the participant's (borrower's) 401(k)
plan account balance is nondeductible if any of the account balance used to
secure the loan is attributable to elective deferrals (i.e., elective salary
reduction contributions the employee signed up for). This is true regardless
of how the loan proceeds are used and regardless of the existence of other
security for the loan, such as the participant's home. Since 401(k) account
balances will almost always include at least some elective deferral dollars,
interest on loans from such plans will usually be nondeductible.
In most cases, borrowing from your 401(k) plan should only be done when
funds are not available elsewhere. But, during this difficult economic time,
it may be prudent to do so. But, for me use this as the last resort.
Please contact us if you have questions on the tax ramifications of
401(k) plan loans or other tax compliance or planning issues.