Finance & Money Management
While you may justifiably feel squeamish about taking out a 401(k) plan loan, it can actually make good sense in appropriate circumstances? assuming it is paid back on time. For instance, in today’s tough economy,
Is Borrowing From Your 401(K) Plan The Best Solution? I
ndividuals who participate in a 401(k) plan sometimes borrow from their plan.
plan loans can be a source of much-needed cash when bank loans are unavailable or prohibitively expensive. 401(k) plan lo- ans are generally economical and easy to obtain. In particular, a 401(k) plan partici- pant with less-than-stellar credit or tapped out credit lines may find it much easier and cheaper to borrow from their 401(k) plan than from a commercial lender. 401(k) plan loans provide participants
with access (within limits) to their 401(k) plan dollars without incurring income tax liabilities and the 10% premature withdra- wal penalty tax. The 10% penalty tax ge- nerally applies to withdrawals before age 59 1/2, however, exceptions are available. In essence, the participant (borrower) pays interest to himself or herself when taking out a plan loan. 401(k) plan loans are only permitted if the plan document allows them, and many plans do. The ma- ximum amount that can be borrowed is generally the lesser of $50,000 or 50% of the participant’s (borrower’s) vested ac- count balance. Most 401(k) plan loans are secured ex-
clusively by the participant’s vested acco- unt balance (although other forms of secu- rity, such as a lien against the participant’s home, are sometimes seen). At least two major potential pitfalls are associated with 401(k) plan loans. First, the participant’s account balance
is irreversibly diminished if the loan is not paid back. Second, the federal income tax conse-
quences are harsh for failure to pay back a plan loan according to its terms, and the loan will usually have to be repaid in full soon after the employee leaves the job for any reason. Such failure to repay the loan can result in a deemed distribution of the unpaid loan balance that triggers a federal income tax hit (possibly a state income
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www.blackeoejournal.com The Black E.O.E. Journal
tax hit, too). In addition, the dreaded 10% premature withdrawal penalty will gene- rally apply unless the participant is age 59 1/2 or older. Interest paid on a loan secured by the participant’s (borrower’s) 401(k) plan ac- count balance is nondeductible if any of the account balance used to secure the loan is attributable to elective deferrals (i.e., elective salary reduction contributions the employee signed up for). This is true regardless of how the loan pro- ceeds are used and regardless of the existence of other security for the loan, such as the participant’s home.
Since 401(k) account ba-
lances will almost always include at least some elec- tive deferral dollars, interest on loans from such plans will usually be nondeductible. In most cases, borrowing from your 401(k) plan
should only be done when funds are not available elsewhere. But, during this dif- ficult economic time, it may be prudent to do so. But, for me use this as the last resort. Please contact us if you have questions on the tax ramifications of 401(k) plan lo- ans or other tax compliance or planning issues.
www.first- taxsolution. com Source:
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