Ah, the double-edged sword of 401(k) loans. Most of us love them…even if it is only for the freedom we feel that they are available to us. However, the double-edge of 401(k) loans is that while we have the freedom to take out the 401(k) loans, there is also the responsibility to repay the loan based on the requirements outlined by the IRS. Before completing your paperwork to take out 401(k) loans, let’s review how you can benefit from this tax and penalty-free transaction, but also the rules you must follow.
Quite simply, one’s ability to take 401(k) loans is based on two simple premises:
1) That when taking out the loan and subsequently re-paying the loan, that all IRS rules related to 401(k) loans are strictly adhered to, and
2) The 401(k) plan documents for the plan in which you are participating permits 401(k) loans to be taken from the plan.
So what are these IRS rules that govern the provision of 401(k) loans within a plan? What must you comply with in the securing and re-payment of the loan back to the 401(k)?
Again, provided 401(k) plan documents permit, a participant can take a loan(s) at any time from the plan. The plan will identify any numerical restrictions on how many loans can be outstanding at any time. However, there are some rules where the plan documents will not have discretion. The rules are:
1) $50,000/50% rule — A participant can only borrow up to $50,000 or 50% of their account balance, whichever is less…period. Whether this occurs in one or more loans, this is a strict limit. Just because they may qualify up to these amounts does not mean they have to take out these amounts. For example, if the participant had an account balance of $100,000, they could certainly take out 401(k) loans up to $50,000; however, the participant may only wish to take out $10,000 to pay on credit card debt. This would be absolutely permissible.
As the limit is $50,000 or 50% of the account balance, whichever is less, would that apply to someone who had $1,000,000 in their 401(k) plan account? Yes! How about if an individual had $$80,000 in their 401(k) account? No! The maximum in the second example would be a maximum loan of $40,000 as that would be the lesser of $50,000 or 50% ($40,000).
2) Maximum 5-Year Repayment Schedule — With the exception of a loan taken out for the down payment on a primary residence, the maximum length of a loan is 5 years. As an example, this is not 5 years and 2 months. It is strictly 5 years. The loan must be repaid over an amortization schedule of 5 years. Further, there is no pre-payment penalties of any kind.
3) Legitimate Interest — This is not free money to you. It is a loan and, as such, you are required to make loan payment with legitimate interest. In the eyes of the IRS, what is legitimate interest? It is generally accepted that the interest on the repayment of the loan may be “prime + 1”. In simple terms, if the published prime interest rate (through the Wall Street Journal) was 3.5% when the loan was exercised, the participant would need to charge themselves at least 4.5% interest on the loan.
4) Frequency of Loan Payments — The frequency in which loan payments must be made can be no less than on a quarterly basis. Similar to the fact that there is no pre-payment penalty, the same applies to the frequency of loan repayment. What this specifically means is that a participant could certainly repay the loan on a more frequent basis (e.g., monthly) than a quarterly payment without penalty; however, the loan repayment frequency could not be any less frequent than quarterly (e.g, semi-annually).
Without cheer leading for the reasons why you might want to take out a loan, suffice it to say there are many valid, legitimate reasons in which to do so. Provided you are realistic and disciplined with the loan repayment, you just might find this to be an exciting benefit of the 401(k) plan as IRA plans do not permit such loans.
As always, the information provided is intended to be educational in nature. It is not intended, nor should it be interpreted as, any form of tax, legal, financial or investment advice. You must always consult with your respective professional in all such matters.