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Short Of Funds? Rely On 401(K) Loan In A Pinch

(posted: December 5th, 2016)

Although the main objective for participating in a 401(k) plan is retirement saving, a plan may also provide a temporary solution if you're short of funds.

Strategy:
Borrow from your 401(k), when necessary. As long as you stay within the tax law boundaries, you won't owe any tax or penalty. You'll have to pay yourself back, with interest, so you'll be reaping extra benefits.

Here's the whole story:
Typically, a 401(k) plan permits employees to make hardship withdrawals.

This is allowed only if you have an immediate and heavy financial need and lack other resources. Also, hardship distributions are subject to income tax and a 10% early withdrawal penalty if they occur before age 59 1/2.

Conversely, if your 401(k) plan includes a loan feature, you can sidestep dire tax consequences. You don't owe any tax on a loan as long as the borrowed amount doesn't exceed the lesser of:

  • $50,000 or
  • 50% of the present value of your nonforfeitable accrued benefit under the plan (i.e., your vested balance).

However, a loan of up to $10,000 is permissible, even if it's more than half of your accrued benefit. If your company's 401(k) plan doesn't have a loan feature, amend the plan documents to provide this option.

8 requirements for Adding a Loan Feature to 401(k) Plans.

  1. Availability:
    Loans must be available to all participants on a reasonably equivalent basis. Loans must be available without regard to race, color, religion, sex or national origin. Plans can consider only factors that commercial lenders would take into account, such as creditworthiness and financial need.
  1. Nondiscrimination rules:
    A loan cannot be made available to highly-compensated employees, officers or shareholders in amounts greater than those made available to other employees. This condition will not be violated merely because the loans do not exceed a maximum amount or a maximum percentage of a participant's vested account balance.
  1. Specific plan provisions:
    Loans must be made under specific provisions contained in the plan. The plan must state the procedure for applying for loans, the basis on which loans are approved or denied, the limitations on types and amounts of loans, the procedure for determining a reasonable rate of interest, the collateral that may secure loans and an explanation of default and how the plan will deal with it.
  1. Length of term:
    Loans must be repayable within five years.
  1. Reasonable rate of interest:
    A loan must charge a reasonable rate of interest. This test is met if the rate charged is similar to what banks or other commercial lenders would charge under similar circumstances.
  1. Adequate security:
    Loans must be adequately secured. In other words, you need more than just a promise to pay, there must be security that could be sold so that the plan would suffer no loss of interest or principal. The regulations allow plans to permit the participant to use up to one-half of his or her vested account balance to secure loans. In other words, if loans are limited to 50% of a participant's vested account balance, the plan can avoid the need for additional security.
  1. Frequency of payments:
    Payments must be made in quarterly installments or at more frequent intervals (e.g., monthly, weekly, etc.).
  1. Amortization:
    There must be level amortization of the loan principal.

Tip: 401(k) plan loans should be a last resort.

Please Contact us with your questions or concerns.

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