Read this before taking out a 401 (k) loan

Sometimes it is inevitable to take a loan against the company's pension plan. Fair enough. Desperate times require desperate measures. But make sure you understand what happens if you are unable to repay the loan according to the terms. This is what you need to know to avoid the tax traps.

Pension Plan Loan Fundamentals

You, as a participant in an employer-sponsored Qualified Pension Plan, can borrow money from the plan if it allows a loan. The loan amount cannot exceed the least of: (1) $ 50,000 or (2) 50% of your equity or accrued benefits. However, a loan of up to $ 10,000 is allowed even if it exceeds the 50% limit.

Plan loans must require substantial level payments made at least quarterly. Apart from the main mortgage, plan loans must be repaid within five years.

Mortgages must be used to obtain a home that will be used as your principal residence and may have longer repayment periods. Loan repayment must be in substantial amount and must be paid at least quarterly.

So far, so good. However, if you are unable to make a payment with a loan on the due date or within the specified deadline, the error can trigger a loan default and a deemed taxable distribution equal to the full amount of the loan balance. In other words, the loan is extinguished, but it is considered paid with the taxable distribution from the plan to you. Not good from a tax perspective.

Warning: Leaving your company will cause your plan loan to expire, although you may have some extra time to make the money. Failure to do so will result in you being treated as receiving a taxable distribution equal to your unpaid loan balance.

Finally, an early eligible plan distribution, including a considered distribution caused by a plan loan default, can trigger a 1[ads1]0% early distribution penalty on top of the income tax hit. The 10% penalty applies if you are under 59½ years, unless an exception is available. (For exceptions, see here.)

The Tax Court's decisions make the point

In a 2017 decision, the tax court concluded that a 401 (k) plan loan taken by the taxpayer before she left on leave was turned into a deemed taxable distribution to her when she failed to start making repayments on time and failed to make the repayments in substantial level amounts. The estimated distribution was also hit with a 10% penalty for early distribution. It did not matter that the taxpayer's employer ignored her instructions to withdraw the repayments from her paychecks during the period she was on leave or that she eventually repaid the loan.

In another tax court case, the taxpayer defaulted on his 401 (k) plan loan after he lost his job. After an audit, the tax authorities said he had to treat the default as a taxable distribution to him during the year the plan's repayment period for repayment expired. The repayment period for a plan loan cannot continue beyond the last day of the calendar quarter after the calendar quarter where the required installment was due. The taxpayer was also hit with a 10% penalty for early distribution. The Tax Court agreed with the tax authorities on all points.

Another Disadvantage

Another thing to keep in mind when considering taking out a plan loan is that your account balance may be irreversibly reduced if you do not repay the loan. That's because the tax law places strict limits on how much you can contribute to your account each year. You may not be allowed to make annual contributions to your account while your plan loan is outstanding.

The Good News

When you take out a plan loan, you basically pay the interest on yourself instead of losing it to some third party. And getting a plan loan can be a lot easier than a commercial loan. And the interest rate on a plan loan can be much lower.

Oh, and by the way: You can't usually deduct interest on 401 (k) and 403 (b) loans

Say your plan loan is secured with 401 (k) or 403 (b) account balance. If any of the account balance comes from payroll deductions that have been withheld from your paychecks over the years, you cannot deduct any of the interest rates. Almost every 401 (k) or 403 (b) account balance includes at least a few dollars from salary reduction contributions. Therefore, interest on loans from these types of plans is rarely deductible.

That said, you can be the exception. Your 401 (k) or 403 (b) account balance may have been solely funded by employer contributions and related earnings. Or, your plan loan can only be secured by the portion of the account balance that can be attributed to employer contributions and related income and to other assets, such as your home. If you are fortunate enough to be in one of these rare categories, you may be able to deduct interest by the general rules that apply to interest paid by an individual taxpayer. For example, if you use the borrowed funds to pay a down payment on a principal residence, you may be able to treat the interest rate as a deductible qualified mortgage interest. If you use the borrowed funds to buy things for your own business sideline, you can probably deduct the interest as a business expense. Consult your tax advisor for complete information on the deductible issue.

The point

Taking out a pension loan may make sense under the right circumstances, but you must understand that default can cause serious tax consequences. And it does not require much to be considered as a default under the tax rules. So be sure to pay back on time before you pull the trigger. Finally, you may not be able to deduct interest on a plan loan.

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