Tax Guy: Read this before you take out a loan on your 401(k)

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Sometimes taking out a loan against your company retirement plan balance is an unavoidable necessity. Fair enough. Desperate times demand desperate measures. But make sure you understand what happens if you fail to repay the loan according to its terms. Here’s what you need to know to avoid the tax traps.

Retirement plan loan basics

You as a participant in an employer-sponsored qualified retirement plan can borrow money from the plan if it allows loans. The loan amount cannot exceed the lesser of: (1) $50,000 or (2) 50% of your vested account balance or accrued benefit. However, a loan of up to $10,000 is allowed even if it exceeds the 50% limit.

Plan loans must call for substantially level payments that are made at least quarterly. Except for principal residence loans, plan loans must be repaid within five years.

Principal residence loans must be used to acquire a residence that will be used as your principal residence, and they can have longer repayment periods. Loan repayments must be in substantially level amounts and must be paid at least quarterly.

So far, so good. But if you fail to make a plan loan payment by the due date or within the specified grace period, the failure can trigger a loan default and a deemed taxable distribution equal to the entire amount of the loan balance. In other words, the loan is extinguished, but it is deemed to be paid off with the taxable distribution from the plan to you. Not good from a tax perspective.

Warning: Leaving your company will cause the plan loan to become due, although you may be given some extra time to come up with the money. If you fail to do so, you are treated as receiving a taxable plan distribution equal to the unpaid loan balance.

Finally, an early qualified plan distribution, including a deemed distribution caused by a plan loan default, can trigger the 10% early distribution penalty tax on top of the income tax hit. The 10% penalty applies if you are under age 59½, unless an exception is available. (For the exceptions, see here.)

Tax Court decisions make the point

In a 2017 decision, the Tax Court concluded that a 401(k) plan loan taken out by the taxpayer before she went on leave was turned into a deemed taxable distribution to her when she failed to begin making repayments on time and failed to make the repayments in substantially level amounts. The deemed distribution was also hit with the 10% early distribution penalty tax. It did not matter that the taxpayer’s employer disregarded her instructions to deduct loan repayments from her paychecks during the period she was on leave or that she eventually repaid the loan.

In another Tax Court case, the taxpayer defaulted on his 401(k) plan loan after he lost his job. After an audit, the IRS said he had to treat the default as a deemed taxable distribution to him in the year the plan’s grace period for repayment expired. A plan loan’s grace period cannot continue beyond the last day of the calendar quarter following the calendar quarter in which the required installment payment was due. The taxpayer was also hit with the 10% early distribution penalty tax. The Tax Court agreed with the IRS on all points.

Another drawback

Another thing to keep in mind when considering taking out a plan loan is that your account balance may be irreversibly diminished if you don’t pay the loan back. That’s because the tax law imposes strict limits on how much you can contribute to your account each year. Also, you may not be allowed to make annual contributions to your account while your plan loan is outstanding.

The good news

When you take out a plan loan, you’re basically paying the interest to yourself rather than losing it to some third party. And it may be much easier to obtain a plan loan than a commercial loan. And the interest rate on a plan loan may be much lower.

Oh, and by the way: You usually can’t deduct interest on 401(k) and 403(b) loans

Say your plan loan is secured by your 401(k) or 403(b) account balance. If any of that account balance is from salary-reduction contributions that have been withheld from your paychecks over the years, you can’t deduct any of the interest. Almost every 401(k) or 403(b) account balance includes at least some dollars from salary-reduction contributions. Therefore, interest on loans from these types of plans is rarely deductible.

That said, you may be the exception. Your 401(k) or 403(b) account balance might have been funded exclusively by employer contributions and related earnings. Or your plan loan could be secured exclusively by the portion of your account balance attributable to employer contributions and related earnings and by some other asset, such as your home. If you’re lucky enough to be in one of these rare categories, you may be able to deduct the interest under the general rules that apply to interest paid by an individual taxpayer. For instance, if you spend the borrowed funds to make a down payment on a principal residence, you may be able to treat the interest as deductible qualified residence interest. If you spend the borrowed funds to buy stuff for your self-employed sideline business, you can probably deduct the interest as a business expense. Consult your tax adviser for full details on the deductibility issue.

The bottom line

Taking out a retirement plan loan can make sense in the right circumstances, but you must understand that defaulting can trigger dire tax consequences. And it doesn’t take much to be considered in default under the tax rules. So be very sure that you can repay on time before pulling the trigger. Finally, you may not be able to deduct the interest on a plan loan.

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