Tax Alerts

Beware potential tax issues with 401(k) loans

At first blush, taking out a plan loan can sound like easy, tax-free money.

However, borrowing against a company 401(k) is anything but. The rules are tricky and violations can trigger costly taxes and penalties — exactly at a time when your funds are least likely to be available. This is precisely where financial advisors can step in and provide a valuable service to you. By understanding the plan loan rules, they will be equipped to counsel you on whether a taking a plan loan is a good or bad idea, given your unique personal situation.

The advantages of such loans are initially seductive. In addition to providing early access to a portion of retirement accounts, they also:

  • Are generally easier to obtain than other bank financing (poor credit does not factor into approval process).
  • Are initially tax- and penalty-free, and continue to be so, if all the conditions are met.
  • Have lower interest rates than loans available elsewhere.
  • Require repayments back to your individual account — not a bank.
  • Allow for optional loan provisions that can always be adopted — even to most pre-approved plans.

To qualify for this preferential tax treatment, the following conditions must be met: the plan document must permit loans; loans are limited to the maximum amount; the repayment period must fall within the statutory period; repayments must be continuously made on at least a quarterly basis; and interest will be assessed on repayments.

You should be aware that plans loans allow participants early access to only a portion of their retirement accounts. That’s because the tax code limits plan loans to the lesser of 50% of the vested account, or $50,000.

There is one exception to this rule: If 50% of the vested account balance is less than $10,000, the participant can borrow up to $10,000 (not to exceed the vested account). However, this exception is optional, and plans can choose to ignore this.

Read the complete article from the October 11, 2019, post in Financial Planning here.  Or, contact a Dugan & Lopatka tax professional at (630) 665-4440 or to guide you through the intricacies of 401(k) loans. 

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