Economic fallout from the COVID-19 pandemic may cause some cash-strapped individuals to consider taking loans from company qualified retirement plans, including 401(k) and profit-sharing plans.
Although this option can provide cashflow to help bridge the gap for some, others may find they are unable to repay the loans in a timely manner due to unforeseen circumstances. Defaulting on a plan loan causes adverse tax and retirement-saving consequences. Evaluate this option carefully prior to making a decision.
Retirement Plan Loan Basics
A participant in an employer-sponsored qualified retirement plan can borrow money from the plan if it allows loans. Under the normal rules, the loan amount can’t exceed the lesser of:
• $50,000, or
• 50% of the participant’s vested account balance or benefit.
However, a loan of up to $10,000 can be permitted even if it exceeds the 50% limit.
Plan loans must call for substantially level payments that are made at least quarterly. Except for principal residence loans, plan loans generally must be repaid within five years. Principal residence loans must be used to acquire a residence that will be used as the plan participant’s principal residence. These loans can have longer repayment periods.
COVID-19 Era Liberalizations
The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) temporarily liberalizes the plan loan rules in two key ways. First, loan payments that would otherwise be due between March 27, 2020, and December 31, 2020, can be suspended for up to one year. Payments due after the suspension period will be adjusted to reflect interest that accrued during the suspension period.
Second, for plan loans made between March 27, 2020, and September 22, 2020, the maximum loan amount can be increased to the lesser of: 1) $100,000 minus any existing plan loan balances, or 2) 100% of the participant’s vested account balance or benefit.
Tax Consequences of Defaulting
Taking out a retirement plan loan may be a financial lifesaver. But this strategy isn’t right for everyone. Why? If the plan participant (borrower) fails to make a loan payment by the due date or within the plan’s specified grace period, the failure can trigger a loan default and a deemed taxable distribution equal to the entire amount of the loan balance. In other words, the loan is extinguished, but it’s deemed to be paid off with a taxable distribution from the plan.
To make matters worse, a plan distribution — including a deemed distribution caused by a loan default — can trigger the 10% early distribution penalty tax. The 10% penalty applies if the plan participant (borrower) is under 59½, unless a tax-law exception is available.
Undesirable Side Effect
The tax consequences of a plan loan default are bad. But there’s another side effect that can decrease your retirement nest egg; once a default occurs, the resulting deemed taxable distribution is drained from the account balance — and it can’t be replaced except by making bigger contributions after the fact.
Unfortunately, you may be unable to afford bigger contributions, and the plan’s terms will place limits on how much you can contribute. So, the amount you can have in tax-favored retirement plan status may be permanently reduced.
Last Resort
Taking out a retirement plan loan may make sense in certain financial circumstances. But borrowers must understand that defaulting can lead to negative tax and retirement-saving consequences. So, taking out a plan loan should usually be considered only as a last resort. Contact a Hantzmon Wiebel tax advisor to learn more and explore alternative sources of cash during the COVID-19 pandemic and other times of need.
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Our firm provides the information in this e-newsletter for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisors. Before making any decision or taking any action, you should consult a professional advisor who has been provided with all pertinent facts relevant to your particular situation. Tax articles in this e-newsletter are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided “as is,” with no assurance or guarantee of completeness, accuracy or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability and fitness for a particular purpose.
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