401(k) Loans Can be Useful, but be Careful

There are advantages and disadvantages to borrowing from your 401(k) plan. When my children were in college, I took advantage of such loans, but there are pitfalls you should be aware of.

First, the advantages: A loan can be relatively easy to obtain if your plan document permits it. Poor credit is not a factor. The loan is initially tax free and penalty free. The interest rate charged on the loan is not a significant factor, because you pay the interest back to your account. Accordingly, a high interest rate is not a significant negative factor, although a high interest rate results in a larger loan repayment. If your employer matches your contributions, be sure to make at least the minimum even if you know you will need to take a temporary loan.

Understand that you must repay the loan while you are working for your employer. If you terminate your employment and cannot pay the loan back, the amount of the outstanding loan is taxable at ordinary income tax rates, and you would incur a 10% early withdrawal penalty if you are younger than 59 1/2.

Ed Slott (www.IRAhelp.com), an expert on retirement accounts, points out some other potential pitfalls with these loans. A loan against a 401(k) can cause tax problems if not handled precisely. To qualify for the preferential tax treatment, the plan document must permit loans; loans are limited to a portion of your retirement account balance, the repayment period must fall within the statutory period, repayments must be continually made at least quarterly, and the repayment must include interest repayments.

The tax code limits plan 401(k) loans to the lesser of 50% of the vested account or $50,000 with one exception. If the vested account balance is less than $10,000, you may borrow up to $10,000 if the amount does not exceed the vested amount. This is optional, so not all plans allow this option.

Some plans allow employees to take multiple loans, and to refinance existing loans. Ed Slott points out that the refinancing option might cause a portion of the previous loan to be immediately taxable. Refinancing can result in a situation in which the maximum loan limits were exceeded. The excess over the limit would result in a taxable distribution, as well as a possible 10% early withdrawal penalty.

Slott makes three critical points for individuals contemplating these loans.

–An outstanding plan can have serious tax consequences if you are required to leave employment, whether voluntarily or not. Another option to consider is a hardship withdrawal (if available) or sources of funds outside the plan.

–Always check official plan communications. Do not rely on a written statement or inference by a human resources or plan representative. Such statement will not hold up in court against statements made in an official plan communication, such as a summary plan description. (If you have questions, have your financial planner or attorney review the official plan document).

–Know the difference between deemed distribution and distribution of offset amount. A deemed distribution occurs when one of the tax code requirements is violated. A deemed distribution is taxable and cannot be rolled over. A distribution of offset amount occurs when your account balance is offset by the outstanding loan balance in order to repay the loan. This situation occurs when you leave your job and request a distribution of your account balance. You can rollover this balance to an IRA or another employer plan by April 15 of the year after the offset occurs (or October 15 if you file an extension).

The bottom line: 401(k) loans have some advantages, but they make sense only if you will be able to repay the loan in full at the time you terminate employment. Otherwise look at these loans as a last resort.

(Article written by Elliot Raphaelson)