• LinkedIn
  • YouTube
  • Twitter
  • Facebook
  • Google+

401(k) plan loans: Figuring the payback is a @#$%&!

Get PDF file

by on
in Office Management,Payroll Management

The IRS generally frowns on 401(k) plans that allow employees to take out loans. And it has come down like a hammer when employees whose accounts hold more than $100,000 in vested benefits take out multiple loans during the same year. New guidelines released to IRS auditors encourage them to look closely at whether employees who take out multiple loans have taxable distributions, instead.

Warning: An auditor’s determination that a loan is a taxable distribution may also cause the 401(k) plan to have an operational failure. (TEGE-04-0417-0016)

What is the highest outstanding balance? The amount employees can borrow from their 401(k) accounts 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; and loan agreements must be legally enforceable.

If employees have more than $100,000 in vested benefits, any additional loans they may request are trickier to calculate. Reason: Since 401(k) plans are intended for retirement, Congress wanted to prevent employees from effectively maintaining permanent outstanding loans of $50,000.

According to the IRS, these employees can still borrow up to $50,000, but that $50,000 is reduced by the highest outstanding balance of loans during the one-year period ending the day before the date the second loan is made over the outstanding balance of loans on the date the second loan is made.

The issue for the auditors is what, exactly, does the “highest outstanding balance” mean? The guidelines illustrate that there are two interpretations of this phrase.

Example: Harry has $120,000 in vested benefits. He borrowed $30,000 in February, which he fully paid back in April. He then borrowed $20,000 in May, which he fully paid back in July. Harry goes for a third loan in December.

Option No. 1: The plan can deny Harry’s third loan, because he already borrowed $50,000 ($30,000 + $20,000).

Option No. 2: The plan may identify the highest outstanding balance as $30,000, and permit Harry to take out $20,000 in December.

Auditors are instructed to make no further inquiry if they conclude that the plan uses one of those two options.

PAYROLL PRACTICE TIP: Now may be a good time to take a look at your 401(k) loan program. In addition to the amount employees are paying back through withholding, you must withhold 20% of the loan amount when loans are made, if the loans don’t meet the equal repayment; five-year, or 50% of vested balance/$50,000 rules; or aren’t backed up by legally enforceable agreements. Those distributions are called “deemed distributions.”

Leave a Comment