Do you need cash in a hurry to help pay for a child’s college, a medical emergency or some unforeseen circumstance?
Strategy: Borrow the money from your 401(k) plan if your employer allows it. A 401(k) loan is just what it sounds like—a legal obligation where you borrow money and agree to pay it back.
Make no mistake about it: You’re required to repay the borrowed amount, with interest, to your account. However, you’re effectively paying yourself back. In the meantime, you have use of the funds (although your earnings within the account may be diminished).
Unlike a hardship distribution from a qualified retirement plan, a 401(k) loan is exempt from federal income tax plus the usual 10% penalty tax for withdrawals made prior to age 59½ (see box below). Yet there’s a catch. The amount you borrow can’t exceed the lesser of:
- $50,000 or
- The greater of $10,000 or 50% of your vested benefits in the plan.
Example: Let’s say you have vested benefits of $500,000 in your 401(k) account. In that case, you can borrow up to $50,000 from your 401(k) account without triggering a taxable distribution. Reason: The amount of your loan is limited to the lesser of $50,000 or 50% of your vested benefits.
Now suppose you have $80,000 in your 401(k) account. That changes the result: Your loan is limited to $40,000—the lesser of $50,000 or 50% of your vested benefits.
In other words, if your vested benefits don’t exceed $20,000, you can’t borrow more than $10,000. If your vested benefits exceed $100,000, your loan is limited to $50,000.
Of course, you must deal with a whole lot of red tape to satisfy the various and sundry government regulations in this area. For instance:
- Loans must be available to all participants on a reasonably equivalent basis. Also, in considering whether to make loans, plans can consider only such factors as commercial lenders would take into account, such as creditworthiness and financial need.
- A loan cannot be made available to highly compensated employees, officers or shareholders in amounts greater than those made available to other employees. This condition will not be violated merely because the loans do not exceed a maximum amount or a maximum percentage of a participant’s vested account balance.
- The plan must state the procedure for applying for loans, the basis on which loans are approved or denied, the limitations on types and amounts of loans, the procedure for determining a reasonable rate of interest, the collateral that may secure loans and an explanation of default and how the plan will deal with it.
- A loan must bear a reasonable rate of interest (e.g., a rate similar to what banks or other commercial lenders would charge under similar circumstances).
- Loans must be adequately secured. The regulations allow plans to permit the participant to use up to one-half of his or her account balance to secure loans.
- There must be level amortization and the loan must be repayable within five years (except where the loan is used to acquire the principal residence of the participant).
- Payments must be made in quarterly installments or at more frequent intervals.
The loan option isn’t limited to C corporation employees. Sole proprietors, partners and S corporation shareholders can obtain loans if the proper provisions are made in the 401(k) plan documents.
Tip: Remember that your 401(k) plan is meant to be used for retirement, so use this tax strategy with discretion. Borrow from the plan only after you’ve exhausted other possibilities.
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