Borrowing From Your Retirement Plan
While most of us would rather not take money from our retirement plans until after we retire, we are sometimes left with no alternative. Luckily, most qualified plans offer employees the ability to borrow from their own retirement assets and repay that amount with interest to their own retirement account.
If you find yourself in a financial bind, you may be considering obtaining a loan to meet your immediate financial needs. The question then is should you borrow from your retirement plan or should you look into other alternatives? The answer is determined by several factors, which we will review as well as the general guidelines for plan loans.
Should You Borrow from Your Retirement Plan?
Before you decide to take a loan from your retirement account, you should consult with a financial planner, who will help you decide if this is the best option or if you would be better off obtaining a loan from a financial institution or other sources. The following are some factors that would be taken into consideration:
|The Purpose of the Loan
A financial planner may think it is a good idea to use a qualified-plan loan to pay off high-interest credit-card debts, especially if the credit balances are large and the repayment amounts are significantly higher than the repayment amount for the qualified-plan loan.
The financial planner, however, may not think it makes good financial sense to use the loan to take you and your friends on a Caribbean cruise or buy a car for your child\'s sixteenth birthday.
The Cost of the Loan
The benefit of taking a loan is that the interest you repay on a qualified plan loan is repaid to your own qualified plan account instead of to a financial institution. However, make sure you compare the interest rate on the qualified plan loan to a loan from a financial institution. Which is higher? Is there a significant difference?
The downside is that assets removed from your account as a loan lose the benefit of tax-deferred growth on earnings. Also, the amounts used to repay the loan come from after-tax assets, which means you already paid taxes on these amounts. Therefore, unlike the elective-deferral contributions you may make to your 401(k) plan account, these repaid amounts are not tax deferred.
Effect of Taking the Loan
Some plans will require you to suspend 401(k) elective-deferral contributions for a certain period after you receive a loan from the plan. If this is the case with your 401(k) plan, you will want to consider the consequence of this suspended opportunity to fund your retirement account.
Qualified-Plan Loan Rules
Regulations permit qualified plans to offer loans but the plan is not required to include these provisions. To determine if the qualified plan in which you participate offers loans, check with your employer or plan administrator. You also want to find out about any loan restrictions. Some plans, for instance, allow loans only for what they define as hardship circumstances, such as the threat of being evicted from your home due to your inability to pay your rent or mortgage, or the need for medical expenses or higher-education expenses for you or a family member. Generally, these plans require you to prove that you have exhausted certain other resources. On the other hand, some plans will allow you to borrow from the plan for any reason and may not require you to disclose the purpose of the loan.
Maximum Loan Amount
A qualified plan must operate loans in accordance with regulations, one of which is the restriction on the loan amounts. The maximum amount you may borrow from your qualified plan is either 50% of your vested balance or $50,000, whichever is less. Plans are allowed to make an exception to this dollar limit if 50% of your vested balance is less than $10,000, in which case the maximum the employee can take out is $10,000. However, not all plans make this allowance. Here are some examples demonstrating the maximum loan amounts:
Jane has an account balance of $90,000 in the ABC Company profit-sharing plan. However, of this amount, $60,000 represents Jane\'s vested balance. Jane may borrow up to $30,000 from the plan, which is 50% of her vested balance and less than $50,000.
Jim has an account balance of $200,000 in the ABC Company profit-sharing plan. Jim is 100% vested. Although 50% of Jim\'s vested balance is $100,000, he may borrow only up to $50,000, which is the borrowing limit no employee can exceed.
Mary has an account balance of $15,000 in the ABC Company profit-sharing plan. Mary is 100% vested. Mary may borrow up to $10,000 from the plan even though $15,000 x 50% = $7,500. An exception is made allowing Mary to borrow more than 50% of her vested account balance, providing the amount does not exceed $10,000. (This exception is now allowed by all qualified plans.) However, Mary may be required to provide collateral for $2,500, the amount in excess of 50% of her vested account balance.
What about Repayments?
|Maximum Repayment Period
Generally, qualified-plan loans must be repaid within five years. An exception is made if the loan is used towards the purchase of a primary residence. It is important to note that your employer may demand full re-payment should your employment be terminated (even if you elect to change jobs or leave the employment for other reasons). If you are unable to repay the amount at this point, and the loan is in good standing, the amount may be treated as an offset, which means the amount will be treated as a distribution. The amount would be reported to you and the IRS on Form 1099-R. This amount is rollover eligible, so if you are able to come up with the amount within 60 days, you may make a rollover contribution to an eligible retirement plan, thereby avoiding the income tax.
Like for loans made by financial institutions, an amortization schedule is prepared for qualified-plan loans. The amortization schedule provides the repayment schedule and repayment amount, including interest. Regulations require you to make qualified-plan loan repayments in level amortized amounts at least on a quarterly basis; otherwise, the loan could be treated as a reportable and taxable transaction.
Circumstances Allowing the Suspension of Repayments
Your employer may make exceptions allowing you to defer loan repayments in certain cases. For instance, if you are in the armed forces, your repayments may be suspended for at least the period you had active duty. The loan repayment period is then extended by the period that you had active duty.
Also, if during a leave of absence from your employer your salary was reduced to the point at which your salary is insufficient to repay the loan, your employer may suspend repayment up to a year. Unlike the exception for active members of the armed forces, the loan repayment period is not extended for you because of your leave of absence. Instead, you may be required to increase your schedule payments amounts in order to pay off the loan in the original scheduled time frame.
Loans that do not meet regulatory requirements may be considered as "deemed distributions". For instance, if the loan repayments are not made at least quarterly, the remaining balance is treated as a distribution that is not rollover eligible, which means the amount will be subjected to income tax. If you continue to participate in the plan after the deemed distribution occurs, you are still required to make loan repayments. These amounts are treated as basis (i.e. after-tax contributions) and will not be taxable when distributed.
Your employer may have special forms that you must complete in order to request a loan. If you want to request a qualified-plan loan, check with your employer or plan administrator regarding documentation requirements.
Generally speaking, you cannot take a loan from your IRA as this would result in a prohibited transaction, which is in violation of certain areas of the Internal Revenue Code. A prohibited transaction could result in tax and penalty consequences for the retirement account holder. For instance, if you borrow from your IRA at any time during the year, your IRA is treated as having made a distribution as of January 1 (the first day of the year in which the prohibited transaction occurs) and you would owe tax on it; furthermore, if you are under age 59.5, early-distribution penalties would be imposed on the amount.
Some will argue that a short-term loan is permitted if the amount is rolled over to the IRA within 60 days. Technically, however, this is not a loan but a distribution and a rollover contribution.
Sometimes borrowing is necessary, but there is usually more than one option available for loans. Before borrowing from your retirement savings, you should determine that it's the best financial decision by considering the purpose, the cost and the future effect of the loan. Be sure to contact your financial planner for help with this important decision.
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