Most qualified plans—such as a 401(k) or 403(b) plan—offer employees the ability to borrow from their own retirement assets and repay that amount with interest to their own retirement account. While most of us would rather not take money from our retirement plans until after we retire, we are sometimes left with no alternative.
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. We'll also look at the general guidelines for plan loans.
- Most employer-sponsored retirement plans are allowed by the IRS to provide loans to participants, but borrowing from IRAs is prohibited.
- Loans taken from qualified plans are subject to limits and specific repayment terms.
- While regulations allow plan sponsors to offer loans, they can choose not to or further limit loan amounts and other provisions.
- To decide if borrowing from your retirement plan is the best choice, consider the purpose of the loan and its true cost, such as the loss of tax-deferred growth on investment returns.
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:
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 16th birthday.
True 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 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. Unlike the contributions you may make to your 401(k) plan account, these repaid amounts are not tax-deferred.
The IRS now permits borrowers to keep contributing to their 401(k) plans, but check to see if yours requires you to suspend 401(k) contributions for a certain period after you receive a loan from the plan. This would also cut off any employer matches of your contributions. 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 a plan is not required to include these provisions. To determine whether 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.
If you have a 401(k) still held at a former employer, you are not allowed to take a loan from that account.
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.
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.
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.
An exception may apply if an individual's account has less than $20,000. In this scenario, the individual may be allowed to borrow as much as $10,000 from the account as long as the vested account value is at least $10,000.
Below are some examples demonstrating the maximum loan amounts.
Jane has an account balance of $90,000 in the ABC Company 401(k) plan. 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 401(k) 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 401(k) 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, so be sure to check first. However, Mary may be required to provide collateral for $2,500, the amount in excess of 50% of her vested account balance.
Repaying a Retirement Plan Loan
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 repayment should your employment be terminated or you choose to leave.
The Tax Cuts and Jobs Act of 2017 extended the deadline to repay a loan when you leave a job. Previously, if your employment ended before you repaid the loan, there was generally a 60-day window to pay the outstanding balance. Staring in 2018, the tax overhaul extended that time frame until the due date of your federal income tax return, including filing extensions.
If you are unable to repay the amount at this point, and the loan is in good standing, the amount may be treated as a taxable 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. Note that if you are younger than 59½, you will likely also owe an early withdrawal penalty, unless you meet certain exceptions.
Loan Repayment Schedule
An amortization schedule is prepared for qualified-plan loans, just as for loans made by financial institutions. 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.
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 were on active duty. The loan repayment period is then extended by the period that you were on 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 scheduled payment amounts in order to pay off the loan in the originally 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.
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. In addition, if you are under age 59½, 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.
Special Considerations Due to COVID-19
Certain changes regarding retirement plan withdrawal penalties and tax liability have been put into place following the March 2020 passage of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act).
The changes that have been put into effect apply to what the law calls an eligible participant—a person who has been diagnosed with COVID-19, has a spouse or dependent diagnosed with COVID-19, or has experienced a layoff, furlough, reduction in hours, or inability to work due to COVID-19 or lack of childcare because of COVID-19.
Eligible participants can take an early withdrawal of up to $100,000 from 401(k)s, 403(b)s, 457s, and traditional IRAs without paying a 10% penalty. An individual has up to three years to pay the taxes on the early withdrawal or to redeposit the money back into their retirement account (versus the standard repayment requirement of 60 days).
Retirement plans are not required by law to accept this modification of early withdrawal rules, but most plans are expected to follow suit. The law covers withdrawals made between January 1, 2020, and January 31, 2020.
The Bottom Line
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.