Mechanics of 401(k) Plans – Loans

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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.