If you are considering taking out a loan on your 401K plan it is important to know that there are certain restrictions and rules that you must take into effect. First, you want to make sure that your plan allows for participant loans. The next step would be to review the restrictions and rules according to your particular plan in regard to taking a loan. Last, you want to make sure you are aware of the implications if you become unable to pay the loan back within the terms of the loan. Let’s take a look at what some of the more common restrictions and implications may be.
Step 1: Does your plan allow for participant loans? If the answer here is yes, you can proceed with your research. It is good to be aware that some plans do not allow for loans.
Step 2: Review restrictions and rules. These may vary from one plan to another but there are some general rules to look for:
- Plans will typically have a limit on the amount of money that you can take from your 401K. Some of the most common limitations state that the loan must be the lesser of $50,000 reduced by any outstanding loan that you may already have or 50% of your vested balance.
- Most plans do not allow for a term of more than 5 years.
- The plan will also limit the number of loans that you can have within a given year. Some may be as small as 1 and others may allow for 2 or more.
- When taking a loan from your 401K it is important to know that you will be paying yourself interest, so you will want to see what the interest rate is before requesting a loan.
Step 3: Implications if unable to pay your loan back (including interest).
- If your loan goes into default, depending on the timeframe determined by your plan, your loan will become a distribution to you. When it becomes a distribution there will be tax implications as well as fees incurred in order to do this.
- If you or your employer terminates your employment with the company, the company may require for you to pay back your loan in full at that time or treat the loan as a distribution discussed in 1 above.
Taking out a loan may or may not be a good decision for you, but either way, it is a good idea to ensure you are well informed prior to taking the loan. Prior to taking out any loan it is always a good idea to contact your service provider to ensure that the loan payments you have to make will be an amount you are comfortable making.
For more information and guidelines on participant loans, go to http://www.irs.gov/Retirement-Plans/Plan-Sponsor/401(k)-Resource-Guide—Plan-Sponsors—General-Distribution-Rules
Brie Keckler, CPA