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Borrowing from Your 401K

July 25, 2011 Posted by Tasha Helms
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Individuals who participate in a 401(k) plan sometimes borrow from their plan. While you may justifiably feel squeamish about taking out a 401(k) plan loan, it can actually make good sense in appropriate circumstances?assuming it is paid back on time. For instance, in today’s tough economy, plan loans can be a source of much-needed cash when bank loans are unavailable or prohibitively expensive. 401(k) plan loans are generally economical and easy to obtain.

In particular, a 401(k) plan participant with less-than-stellar credit or tapped out credit lines may find it much easier and cheaper to borrow from their 401(k) plan than from a commercial lender. 401(k) plan loans provide participants with access (within limits) to their 401(k) plan dollars without incurring income tax liabilities and the 10% premature withdrawal penalty tax. The 10% penalty tax generally applies to withdrawals before age 59 1/2, however, exceptions are available. In essence, the participant (borrower) pays interest to himself or herself when taking out a plan loan. 

401(k) plan loans are only permitted if the plan document allows them, and many plans do. The maximum amount that can be borrowed is generally the lesser of $50,000 or 50% of the participant’s (borrower’s) vested account balance. Most 401(k) plan loans are secured exclusively by the participant’s vested account balance (although other forms of security, such as a lien against the participant’s home, are sometimes seen). 

At least two major potential pitfalls are associated with 401(k) plan loans. First, the participant’s account balance is irreversibly diminished if the loan is not paid back. Second, the federal income tax consequences are harsh for failure to pay back a plan loan according to its terms, and the loan will usually have to be repaid in full soon after the employee leaves the job for any reason. Such failure to repay the loan can result in a deemed distribution of the unpaid loan balance that triggers a federal income tax hit (possibly a state income tax hit, too). In addition, the dreaded 10% premature withdrawal penalty will generally apply unless the participant is age 59 1/2 or older. 

Interest paid on a loan secured by the participant’s (borrower’s) 401(k) plan account balance is nondeductible if any of the account balance used to secure the loan is attributable to elective deferrals (i.e., elective salary reduction contributions the employee signed up for). This is true regardless of how the loan proceeds are used and regardless of the existence of other security for the loan, such as the participant’s home. Since 401(k) account balances will almost always include at least some elective deferral dollars, interest on loans from such plans will usually be nondeductible. 

In most cases, borrowing from your 401(k) plan should only be done when funds are not available elsewhere. But, during this difficult economic time, it may be prudent to do so. Please contact us if you have questions on the tax ramifications of 401(k) plan loans or other tax compliance or planning issues.

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