401(k) plans don’t have to allow employees to borrow from their vested account balances. But if they do, the news is grim. According to a recent survey conducted by the Financial Literacy Center, about 10% of employees who borrow from their 401(k) plans default. The default percentage skyrockets to 80% if employees terminate with outstanding loans.
For employers, 401(k) plan loans trigger withholding obligations.
Withholding when loans are made
The amount employees can borrow from 401(k) plans is limited to 50% of their vested balances, capped at $50,000. Employees must repay their loans in equal payments, at least quarterly. Loans usually can’t last longer than five years. Loan agreements must be legally enforceable. Employees customarily repay their loans via wage withholding.
In addition to the amount employees have agreed to pay back through withholding, you must withhold 20% of the loan amount when the loans are made if the loans don’t meet the rule for equal repayment or the five-year or 50% of vested balance/$50,000 rule, or aren’t backed up by legally enforceable agreements. Those distributions are technically called deemed distributions.
Example. Emily’s account balance is $200,000. She receives a $70,000 loan repayable quarterly over five years. Result: Emily has a $50,000 loan and a $20,000 deemed distribution ($70,000- $50,000), since the loan tops the $50,000 limit. Emily’s employer withholds $4,000 when the loan is made. The $20,000 and the $4,000 withheld are reported on a 1099-R form.
Withholding after loans are made
If employees default, the balances, including accrued interest, are deemed distributions. Key: If cash or property is transferred to employees when the deemed distribution occurs, you withhold 20%. If nothing is transferred at that time, you must keep the loan on your books. Small break: You may give employees a grace (or cure) period through the calendar quarter that follows the calendar quarter in which the defaults occurred.
Example. On Aug. 1, 2012, Jean’s vested balance is $45,000. She borrows $20,000, to be repaid over five years in equal payments due at the end of each month. She defaults after the July 31, 2013, payment. The plan administrator allows a three-month grace period. Result: She has a deemed distribution of $17,157 (including interest at a commercially reasonable rate) on Nov. 30, 2013, which is the last day of the three-month grace period for the August payment. Alternatively, the grace period could expire on Dec. 31, 2013 (for a $17,282 deemed distribution), which is the end of the next calendar quarter.
Interest that accrues after the deemed distribution occurs isn’t included in the employee’s income.
Result: Even though interest continues to accrue on the outstanding loan (as it would on any loan), no further withholding or reporting is required.