If you have vested benefits in an employer-sponsored retirement plan, you may be able to borrow money from your employer's plan. If the loan meets IRS guidelines, the loan will not be treated as a taxable distribution. Not all retirement plans allow participants to take loans, however. Check with your plan administrator to see if loans are allowed for your plan.
Like any other loan, a loan from a retirement plan must be repaid. Generally, you have to repay the loan within five years by regular payments, made at least quarterly. The repayment period can be longer if the funds are used to purchase a primary residence. If you fail to repay the loan within the time period allowed, the loan will be treated as a taxable distribution.
If you are paying high interest rates on credit cards or other debts, a plan loan may allow you to pay off your balances and have a lower interest rate. However, as discussed below, taking out a plan loan does have certain tradeoffs.
Requirements to Be Eligible For A Plan Loan
To be eligible to take a loan from an employer-sponsored retirement plan, you must:
- Participate in an employer-sponsored retirement plan that allows loans (not all plans allow loans, so consult your plan administrator for details about your plan)
- Have an adequate vested balance in the plan
- Be classified as a nonowner employee with respect to the plan (unless your plan has been amended)
Caution: The Sarbanes-Oxley Act of 2002 may prohibit retirement plan loans to executive officers of public companies. Check with your plan administrator.
Caution: Loans are not permitted from IRAs or from IRA-based plans such as SEPs, SARSEPs and SIMPLE IRA plans. Loans are only possible from qualified plans (like 401(k) and profit-sharing plans), qualified annuity plans, 403(b) plans, and governmental 457(b) plans.
Plan Loan Limits
The IRS limits the amount of money you can borrow from an employer-sponsored retirement plan. In general, the maximum amount you can borrow (when added to any existing loan balance) is the lesser of:
- $50,000 (reduced by the excess of the highest outstanding loan balance during the one-year period ending on the day the loan is made over the outstanding balance on the date of the new loan), or
- The greater of (1) $10,000 or (2) one-half of the present value of your vested accrued plan benefits
Vested benefit in pension plan
Maximum loan amount (without taking prior loans into account)
Up to $10,000
Total vested amount*
$10,000 to $20,000
$20,001 to $100,000
50% of vested amount
More than $100,000
*Because of security requirements, in most plans the practical limit will be 50% of your vested account balance.
Example(s): Assume you borrowed $17,000 from your retirement plan in year one and your highest loan balance on October 1, year one, was $13,000. It is now October 1, year two. Your vested benefits are $340,000 and your unpaid loan balance is $8,000. In your case, the maximum additional amount you may borrow is $37,000, calculated as follows: Loan limit ($50,000) Minus: Highest outstanding balance in prior 12 months ($13,000) minus current unpaid balance ($8,000) Equals: $50,000 limit minus ($13,000 12-month high balance less $8,000 current balance) = $50,000 minus $5,000 excess = $45,000 loan limit, minus outstanding balance of $8,000 equals $37,000
Caution: If you have more than one plan loan outstanding, all the loans are aggregated when calculating the maximum additional amount you can borrow. If your plan allows refinancing, special rules may apply.
Caution: If you participate in more than one retirement plan sponsored by your employer, those plans will generally be aggregated when determining how much you can borrow.
Note: For a loan made to a qualified individual between March 27, 2020, and September 22, 2020, the $50,000 limit is increased to $100,000 and the 50% limit is increased to 100%. A qualified individual means an individual who is diagnosed with coronavirus or whose spouse or dependent are diagnosed with coronavirus, as well as an individual who experiences adverse financial consequences as a result of factors related to the coronavirus pandemic. These factors may include quarantines, furloughs, the inability to work due to lack of child care, and business closings.
Advantages of Taking Out a Plan Loan
You May Automatically Qualify For a Loan
If your plan offers loans to participants, there is normally no qualification process to borrow from your plan. As long as you are a participant and have an adequate vested balance, you may borrow from your plan. Your vested balance is the amount that would be yours if you left your employer now — that includes your employee contributions and earnings and possibly some or all of the employer contributions and earnings. You are 100% vested in your own contributions. By contrast, employer contributions are generally vested after a certain number of years of service with your employer. Federal laws spell out the maximum time it takes for you to be vested, but your employer may have a faster vesting schedule.
The Interest Rate on Plan Loans Is Usually Favorable
If your plan offers loans to participants, the interest rate on such loans is generally reasonable compared to many other types of loans. A typical interest rate on a plan loan might be only one or two percentage points above the prime rate offered by banks. An unsecured bank loan is usually six or more percentage points above the prime rate. As a result, it may make sense to borrow from your retirement plan to pay off credit card balances or other high-interest debts.
The Interest You pay usually goes into your own account
Most employer-sponsored retirement plans keep participants' accounts separate, which can work to your advantage if you take out a plan loan. Typically, when you make payments of principal and interest on the loan, the plan deposits those payments directly into your individual plan account. This means that you are not only receiving back your loan principal, but you are also paying the loan interest to yourself.
Caution: This advantage is often not as great as it appears. For more information, see below (Disadvantages of taking out a plan loan).
The Interest You Pay Is Sometimes Tax Deductible
If you itemize deductions on your federal income tax return, the interest you pay on a plan loan may be tax deductible. It depends on how you use the loan proceeds. If you use the proceeds to pay off credit cards, the interest is not tax deductible. If the loan is used to purchase a principal residence, however, and the loan is secured by a mortgage on the residence (often in addition to the vested benefits), then the interest may be tax deductible. However, key employees are not eligible for a tax deduction on a plan loan. Also, no deduction is allowed if your loan is secured by your pre-tax deferrals to a 401(k) or 403(b) plan. Consult a tax advisor regarding the specific rules that govern deductibility of plan loan interest.
Note: The Tax Cuts and Jobs Act passed in 2017 doubled the standard deduction for both single and married taxpayers filing jointly, which may make this possible deduction less of an advantage to many taxpayers.
Disadvantages of Taking Out a Plan Loan
You Pay Tax Twice On the Funds You Use to Pay Interest on The Loan
While the interest you pay on a plan loan may be deposited into your individual account, the benefits of this perk are somewhat illusory. Here's why. To pay interest on a plan loan, you first need to earn money and pay income tax on those earnings. With what is left over after taxes, you pay the interest on your loan. When you later withdraw those dollars from the plan (at retirement, for example), they are taxed again because plan distributions are treated as taxable income (except for qualified Roth distributions). In effect, you are paying income tax twice on the funds you use to pay interest on the loan.
The Loan May Become a Taxable Distribution In Some Cases
Unlike other retirement plan distributions, plan loans are ordinarily not taxable or subject to a penalty. However, the loan may be treated as a taxable distribution to you under certain conditions. The borrowed funds would then become subject to federal (and possibly state) income tax, and a premature distribution tax might also apply if you are under age 59½. As a general rule, this will only happen to you if something goes wrong with the loan. For example, if you fail to repay the loan or make payments on time, the IRS will typically treat the loan as a taxable distribution to you. For more information on the taxation of plan loans, see below (Income tax treatment of plan loans).
Tip: If you default on a loan repayment, you may be able to "cure" it and avoid tax consequences. Consult a legal or tax advisor.
The Loan Must Be Repaid When Required
A plan loan must be repaid within the allowable time period to avoid being treated as a taxable distribution. Generally, you have to repay the loan within five years by making regular payments, at least quarterly. The repayment period can be longer if the funds are used to purchase a primary residence. However, the repayment terms may change if you leave your employer's service (whether voluntarily or not) and still have an outstanding balance on a plan loan. In this case, the plan may require that you repay the loan in full within a much shorter time frame.
Example(s): You leave your job and have a $50,000 vested balance in your employer's plan. You still owe $10,000 on a plan loan, so your cash balance is reduced to $40,000. You can roll over the $40,000 or take it in cash. If you take a cash payout, the plan must withhold $10,000 for federal income tax (a mandatory 20% of the full $50,000). So, you actually receive $30,000 — $50,000 minus the $10,000 loan balance and the $10,000 tax withholding. If you decide to roll over the funds after receiving the distribution, you must deposit the full $50,000 in an IRA or another plan within 60 days to avoid taxes and possible penalties.
Tip: Check with your plan administrator regarding repayment requirements. Some plans allow you to continue regular monthly payments if you keep your money in the former employer's plan. If you are now employed elsewhere, check with your new plan administrator. Also, some plans allow you to roll over the balance of your loan (the "plan loan offset"), along with the rest of your plan balance, to another employer plan that accepts these rollovers.
Tip: If you are on a non-military leave of absence either without pay or at a rate of pay that is less than your loan payment, your plan may allow you to suspend your loan payments for up to one year. After the suspension, you must repay your loan within five years of your original loan date (unless the loan was used to buy your main home). If you are on a military leave of absence, your plan may allow you to suspend your loan payments until you return to employment, even if that period is greater than one year.
You must repay your loan within five years of the date of the original loan (unless the loan was used to buy your main home) plus the period of your military leave. In both cases, interest continues to accrue while your loan payments are suspended. However, under federal law, the interest rate that applies to your loan while you are on military leave cannot exceed 6%. Check with your plan administrator to see if you can suspend your payments during a leave of absence.
Note: In the case of a loan outstanding after March 26, 2020, (a) the due date for any repayment that would normally occur between March 27, 2020, and December 31, 2020, may be delayed by a qualified individual for one year; (b) any subsequent repayments are to be appropriately adjusted to reflect the delay and any interest accruing during the delay; and (c) the delay period is disregarded in determining the five-year period and the term of the loan. A qualified individual means an individual who is diagnosed with coronavirus or whose spouse or dependent are diagnosed with coronavirus, as well as an individual who experiences adverse financial consequences as a result of factors related to the coronavirus pandemic. These factors may include quarantines, furloughs, the inability to work due to lack of child care, and business closings.
Plan Loans Have an "Opportunity Cost"
When you take a loan from your employer's retirement plan, the funds you borrow are removed from your plan account until you repay the loan. While removed from your account, the funds will probably not continue to grow tax deferred (unless invested in an annuity or other tax-deferred vehicle). This is known as the opportunity cost of a plan loan, because you miss out on the opportunity for more tax-deferred investment earnings.
The Loan Process
Consult Your Plan Administrator
First, ask your plan administrator if you can take out a loan. While the IRS permits participants in qualified retirement plans (such as 401(k) plans) to borrow from their plans, plans are not required to make loans available. Some plans do not offer a loan option, while others offer it only under limited circumstances (such as proven hardship). Still other plans allow you to have only one loan at a time. Your plan administrator can also tell you the repayment requirements if you leave your job, and which assets (if any) must be used as security for the loan.
Compare a Plan Loan with Other Alternatives
Determine how much you need to borrow to meet your needs. Then, compare the cost of borrowing that amount from your employer's plan with other financing options, such as banks, credit unions, friends, and family members. To do an adequate comparison, you must consider:
- Interest rates with each alternative
- Whether the interest will be tax deductible from one source as compared to another
- The amount of investment earnings you may miss out on by removing funds from your tax-deferred retirement plan
Request the Loan from Your Plan Administrator
If you find that it makes sense to take out a plan loan, request the loan from your plan administrator. Loan application procedures vary by plan. Some require a formal application, while others allow you to apply for a loan on-line, or over the telephone. Check with your plan administrator on how to apply for a loan from your plan. Also, ask your plan administrator if your spouse's consent is required to borrow from your plan. If so, you will need to obtain the necessary consent from your spouse in a timely manner.
Find Out How Your Plan Funds Its Loans
Ask your plan administrator whether the loan money will come directly from your account balance and where repayments will be allocated. If you participate in a defined contribution plan (such as a 401(k) plan) that maintains individual accounts, the money will usually come right from your account. As the loan is repaid, principal and interest payments are credited to your account. On the other hand, if your plan does not maintain individual accounts, the plan will treat your loan as an investment of the entire plan. As you repay the loan, principal and interest payments will be credited to the entire plan.
Make Sure That Certain Guidelines Are Being Followed
Your plan administrator should make sure that these plan guidelines on participant loans are being followed:
- Plan loans must be available to all participants on a reasonably equivalent basis. Loan availability must not be based on illegal discriminatory factors, such as race, religion, sex, color, national origin, etc.
- The only factors that may be considered are those that a commercial bank would use in approving or disapproving loans.
- Your plan may require adequate security, but you may not be unreasonably denied a loan.
- Your plan may require a minimum loan amount of up to $1,000 and may limit loans to certain purposes such as hardship or college tuition. The limitations must be applied on a reasonably equivalent, nondiscriminatory basis.
- Plan loans must not be available in greater amounts to highly compensated employees.
- Plan loans must follow the participant loan program contained in the retirement plan or in a separate written document that is part of the plan. The loan program must include (1) clear permission for the establishment of a loan program, (2) the identity of who administers the program, (3) a loan application procedure, (4) a basis for approval or denial of loans, (5) any stipulations on types of loans offered, (6) a procedure for deciding equitable interest rates, types of collateral admissible to secure loans, and the events that constitute default, and (7) how the plan will maintain its assets if a borrower defaults.
- Plan participants must be charged a reasonable rate of interest. Many plans also charge loan processing and administrative fees.
- Plan loans must be adequately secured by more than simply a promise to repay. If you default on the loan, it will be deemed a taxable distribution to you and you may be subject to penalties if you aren't at least age 59½. You may use up to 50% of your vested benefits as security, but your loan balance can't exceed $50,000. If the amount you want to borrow is more than 50% of your vested benefits, as in a situation where your vested benefit is less than $20,000 and you want to borrow the maximum permissible amount ($10,000), you must provide other security. The requirements and limitations imposed by federal law regarding qualified plan loans are intended to ensure that a legitimate debtor-creditor relationship has been created. While your plan must follow these requirements, check with your plan administrator for specific details.
Repay the Loan
As discussed, you generally must repay your plan loan within five years through payments made at least quarterly. You can have a longer time to repay if your loan is used to purchase a primary residence. Most plans require repayment through payroll deduction. Again, if you fail to meet your loan's repayment requirements, the loan may be classified as a taxable distribution.
Income Tax Treatment of Plan Loans
A retirement plan loan is generally not a taxable distribution to you if everything is done properly. However, your plan loan may lose its tax-free status if any of the following applies:
- The loan is too large. The amount of your plan loan cannot exceed the maximum loan amount available to you based on your vested balance and any prior loans.
- Your loan repayment period is too long. You generally must repay the loan within five years (a loan used to buy a principal residence may allow a longer period), or if you leave your employer's service, by your tax filing deadline, including extensions (generally, October 15 of the year following the year you leave).
- Within the specified repayment period, you fail to make payments at least quarterly (except in special circumstances) or amortize the payments equally over the term of the loan.
- You did not sign a legally enforceable agreement that specifies the loan amount, the loan term, the interest rate, and the repayment schedule. In any of these cases, the IRS may treat your plan loan as a taxable distribution to you. This means that the funds will be included in your taxable income for federal (and perhaps state) income tax purposes. A 10% federal premature distribution tax (and perhaps a state penalty) may also apply if you are under age 59½. Consult a tax advisor for further guidance on taxation of plan loans.
Caution: If you default on a plan loan, and it is still unpaid, your ability to receive an additional plan loan may be limited unless you provide additional security. Check with your plan administrator.
Tip: If you have ever made after-tax contributions (including Roth 401(k) and Roth 403(b) contributions) to your employer's retirement plan, those amounts will not be included in your taxable income when distributed to you. However, a plan loan that is treated as a taxable distribution under the rules described above can never be a qualified distribution. As a result, any earnings treated as distributed to you will generally be subject to income tax (and the 10% premature distribution tax if you are under age 59½).
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