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Mechanics of 401(k) Plans – Loans

Image courtesy of Stuart Miles at FreeDigitalPhotos.net

Image courtesy of Stuart Miles at FreeDigitalPhotos.net

Continuing our series of articles on the mechanics of 401(k) plans, today we’ll talk about loans from the account.  As with all of these articles, we’ll refer generically to the plans as 401(k) plans, although they could be just about any Qualified Retirement Plans (QRPs), including 403(b), 457, and other plans.

Unlike IRAs, 401(k) plans allow for the employee-participant to take a loan from the plan.  There are restrictions on these loans, but they can be useful if you need funds for a short-term period and have no other sources.

401(k) Loans

If you have a balance in your 401(k) account, often your plan administrator will have a provision allowing you to take a loan of some of the funds in the account. (Not all plans allow loans – this is an optional provision, not a requirement.)  Sometimes the plan administrator will place restrictions on the use of the loan – such as for education expenses, medical expenses, or certain housing costs.

These loans are limited to the lesser of 50% of your vested balance or $50,000.  If your vested account balance is less than $20,000, you are allowed to take a loan up to $10,000 or 100% of your vested balance.  It is allowed to have more than one loan from your 401(k) plan at a time, but the limits mentioned above apply to the aggregation of all loans at any time.

Loans from your 401(k) plan must be paid back over a specific period of time, not to exceed 5 years from the loan origination.  If the loan is for purchase of the participant’s primary residence, the plan administrator may extend the repayment period of the loan.  In addition, loan payments must be on a set schedule of substantially equal payments, including both interest and principal – and payments must at least be quarterly.  Loan payments are not considered to be plan contributions (when considering annual contribution limits).

If the loan is not repaid according to the schedule, any unpaid balance is considered to be a taxable distribution from the plan – but not a usurpment of rules regarding in-plan distributions.  In other words, if a plan only allows in-plan distributions to employee-participants who are over age 59½ and an employee under that age defaults on a loan, the deemed distribution is not outside the rules of an in-plan distribution.

Loan payments can be suspended for up to one year for a period of absence by the employee-participant, but the original loan repayment period still applies.  In other words, if an employee with a 401(k) loan in repayment status takes a leave of absence and payments are suspended, upon the shorter of his return to work or 1 year, the suspended payments have to be made up.  This is done via either increased payments for the remainder of the loan period, or a lump-sum payment at the end of the period.

Loan payments can also be suspended for employees performing military service – such as called-up reserves.  The time limit of 1 year (as above) doesn’t apply to these suspensions.

Interest on the loan can vary by the 401(k) plan, but most common is to use a rate such as “Prime plus 2%”.

Unless you default on the loan, the proceeds are not taxable, since you’ve only borrowed them and are paying back the funds, usually via payroll deduction.  The payments back into the plan are taxable income, since they are not considered to be “regular” contributions to the account.

5 Comments

  1. LinNo Gravatar says:

    If you are able to expand on this topic, two ideas are (1) what happens to unpaid loan balances when an employee resigns or loses her job and can’t repay? What are the options, implications, etc. and (2) what happens when an employee with a loan dies? If not repaid will it default with the 1099 issued to the estate or to the beneficiary? If to the estate and if the estate is insolvent, maybe that beats the IRS out of the tax?

    1. jblankenshipNo Gravatar says:

      Lin –

      Can’t believe that I left out the treatment of unpaid loans upon the employee leaving the job. When this occurs, the former employee typically has a short period of time (for example, 30 days) in which to repay the loan. If not repaid during that period, the remaining balance is considered a distribution from the plan, and is taxable and possibly subject to early withdrawal penalty.

      The same is true for the death of a current plan participant with an outstanding loan – if not repaid then the difference is removed from the remainder of the account and that difference is considered to be taxable income to the plan participant’s estate. However, another view of this could be that the beneficiary(ies) of the plan effectively “received” the distribution, and therefore the tax as well. Sorry that I don’t have a more definitive answer – none of my sources had a specific answer as well. I would take the tack that even if the estate is insolvent, the IRS will come after someone for the tax.

      jb

  2. […] Blankenship shares Mechanics of 401(k) Plans – Loans  shedding light on this often misunderstood aspect of 401(k) plans at Getting Your Financial […]

  3. JenniferNo Gravatar says:

    Thank you for such a useful and timely article. I’ve read that there isn’t clear guidance on loan interest rates but some IRS official stated in a speech that “prime + 2%” is likely considered reasonable by the IRS. Is it your understanding that prime + 1% is okay with the IRS? Thanks.

    1. jblankenshipNo Gravatar says:

      Jennifer –

      The old rule of thumb used to be prime+1%, but in the recent lower prime rate environment the standard has been increased to prime+2%. My apologies for any confusion this has caused. I’ll update the article for clarity.

      jb

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