401k Loans
Advantages and Disadvantages
of 401k Loans
Terminating Employment When
There's An Outstanding Loan
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Entering Approved Loans Into
the System
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Entering Loans and Repayments
Into Your Payroll Software
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Entering Monthly Loan
Repayments Into the System
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Interfacing with the
Investment Account Company
Introduction
401k loans are an extremely popular option with 401k participants. They can prove costly to the participant over the long run in terms of lost compounding investment returns, but to many participants the money foregone is worth the freedom of having access to the 401k capital before retirement.
When a plan participant takes out a 401k loan, the participant is, in effect, borrowing from himself or herself. Investment shares worth the amount requested are liquidated, the money is handed over to the plan participant, and the loan is repaid (generally through automatic payroll deductions along with the normal 401k monthly contributions) over a period of 1 to 10 years, depending on the purpose of the loan.
There is an interest charge attached to the loan, of course, but the interest is a cost of borrowing that the employee pays to himself or herself: all the loan repayments and interest payments go back into the employee's 401k account and are distributed among the participant's chosen 401k investments just like regular 401k contribution are. However, there is a tax disadvantage in that the payroll deductions to repay the loan come out of taxable income and the 401k loan interest is not tax-deductible even if the loan proceeds are used to buy the participant's primary residence.
401k Tips:
Businesses may sponsor 401k savings programs for employees. Through payroll
deduction, employees set aside small amounts for deposit into a 401k contract.
An employer can make 401k contributions for all or select employees. In such
instances, the recipient's reported annual taxable salary will include the
contribution, although this amount would then be deducted (conditions
permitting) by the employee on his or her year-end tax filing. Target
Laboratories (www.targetlab.com) has
deployed such a plan for its employees.
Advantages and Disadvantages of 401k Loans
Table 5-1 summarizes the advantages and disadvantages of 401k loans. Each would-be borrower should be made aware of these advantages and disadvantages.
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Table 5-1. Advantages and Disadvantages of 401k Loans |
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Advantages |
Disadvantages |
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Plan participants can borrow up to 50% of vested account balance, up to a maximum of $50,000. Interest paid on the loan goes back into the participant's account. Repayment (interest and principal) are automatically deducted by Payroll. The participant has up to five years to repay the loan, 10 years if the loan is for purchase of a primary residence. Participants can access money that otherwise would not be available until retirement. A 401k loan interest rate is probably lower than the participant could get elsewhere. |
The participant "borrows" his/her own money: It's not really borrowing but taking out of savings. Money loaned out isn't earning any investment returns; "interest" paid by the participant on the loaned money is merely a way of trying to compensate for what would have been earned. In cases of a default, the loan amount outstanding is considered a premature 401k distribution on which the person will owe income tax plus a 10% penalty if the person is younger than 59 1/2. Repayments (principal and interest) are made with after-tax dollars -- and when the participant withdraws the repaid money after retirement, he/she will pay tax on it a second time. If the loan is used to buy a primary residence, the interest paid is NOT tax deductible, which it would be for a conventional home loan. If the borrower leaves the company before the loan is repaid, he/she must pay the balance due or the unpaid balance will be treated as an early distribution and subjected to the penalties and taxes of such. |
Because of the considerable financial implications for the borrower, your 401k's standard materials limit loans to serious needs — using the same criteria as for hardship withdrawals. We recommend that your company maintain such a stringent loan policy. Often the borrower leaves the company before the 401k loan is paid in full, and must come up with the cash to pay off the loan or treat the unpaid balance as an early distribution (see “Terminating Employment When There's an Outstanding Loan,” below). Thus the borrower can be faced with a financial difficulty or a tax problem at a time when he or she is either unemployed or starting a new job.
Loan policies are set by your company. The loan application in the 401k Loan Pac gives guidelines, but these are not programmed into your plan administration software. If your plan allows loans, your company must have a separate written document describing the specifics of your loan program and must designate a Loan Administrator, who may or may not be the same person as you, the Plan Administrator. Here, we assume that the Plan Administrator and Loan Administrator are the same person.
As Loan Administrator you are responsible for, at a minimum:
• Reviewing and approving (or denying) the participant's loan application;
• Setting the interest rate and term of the loan; and
• Determining the allowable amount of the loan.
You also should make sure the loan applicant understands the disadvantages to the applicant of 401k loans, that he or she can have only one loan outstanding at any one time, and that a loan may be granted no more than once in any 12-month period.
One disadvantage to the company is that processing loans can be time-consuming and therefore costly. However, you are allowed to set reasonable annual fees ($25 to $30) for setting up and administering loans and to pass these fees on to the employee. These fees cannot be deducted from either the loan repayments or the employee's normal 401k contributions. They must be paid using after-tax money. We recommend a written check issued by the borrower and made payable to the sponsor. The loan fees may be used by the sponsor to offset routine 401k plan costs.
The customized 401k Loan Pac is a complete package that includes loan policy guidelines, terms and conditions, step-by-step procedures, and all the necessary forms. It is important that you thoroughly familiarize yourselves with the contents of this package before giving it to an employee, and that you explain the loan provisions of your 401k plan to the employee.
IMPORTANT!!!
It
is especially critical that the applicant realize the importance of the
promissory note. This note must be signed before any loan can be finalized. If
a participant fails to complete the promissory note, the loan could be
considered an early distribution from the plan and taxes would apply.
An employee cannot take a loan in excess of the allowable maximum (50 percent of the vested account balance up to $50,000). In addition, your plan administration software applies the following restrictions:
• Minimum loan amount is $1,000.
• Loans for amounts between $1,000 and $1,999 must be repaid within 12 months or less.
• Loans for amounts between $2,000 and $2,999 must be repaid within 36 months or less.
• Loans between $3,000 and $50,000 must be repaid within 60 months or less.
• Ten-year loans for residences cannot be for less than $6,000 and not more than $50,000.
Employer qualified non-elective contributions (QNECs) can be considered a part of the employee's account value for a loan.
Terminating Employment When There's an Outstanding Loan
An employee who terminates employment before the loan is paid off has two options:
1. Pay in full the outstanding loan balance, or
2. Have the outstanding balance treated as a taxable distribution.
In the latter case, the balance is reported to the IRS on a 1099-R as taxable income for the current year. The employee is responsible, not only for the income tax on this income, but also for a 10% penalty for a premature distribution (if he or she is less than 59 1/2 years of age).
A grace period of up to 90 days is generally allowed. If the employee has more than $5,000 in his or her account, including the loan, and during this grace period does not repay the loan or elect to have the balance treated as taxable income, the loan is treated as a taxable distribution and reported to the IRS on a 1099-R.
If the employee has less than $5,000 in his or her account, including the loan, and does not elect either of the above options during the grace period, you may make a distribution of his or her entire vested account balance. The mandatory 20% federal withholding applies, and the amount reported on the 1099-R includes the employee's vested account balance plus the remainder of the outstanding loan principal.
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Answers to 401k Distributions & Loans
Q: How are benefits paid from a 401(k) plan? A: Distributions from a 401(k) plan may be made in the form of a lump sum distribution; a direct rollover to another qualified plan or IRA; installments over a fixed period including the life expectancy of the recipient; or an annuity that provides periodic payments over the life expectancy of the recipient.
Q: What is the latest date that we must distribute an employee's 401(k) money? -TOP A: A 401(k) plan must provide that, unless a plan participant makes a request to the contrary, the money in a plan participant's 401(k) account will be paid no later than the 60th day after the end of the plan year in which the latest of three events occurs: (1) the participant reaches either age 65 or the normal retirement age specified in the plan, whichever is earlier; (2) the 10th anniversary of the year in which the participant joined the plan; or (3) the participant terminates employment. However, if the participant terminates employment or is a 5-percent owner of the employer, whether or not employed, a distribution from the plan must occur (or begin, if it is in the form of a series of payments) no later than April 1 of the year following the year in which such employee reaches age 701/2.
Q: What is the earliest that employees are entitled to their 401(k) money without incurring penalties?-TOP A: Penalty-free distributions from a 401(k) plan are permitted only when a plan participant dies, becomes disabled, reaches age 591/2 or separates from service after age 55. Also, distributions paid on termination of employment over the life expectancy of the participant are exempt from any additional taxes. Distributions that do not qualify under one of these criteria, including hardship withdrawals, are early withdrawals, and are subject to a 10-percent additional tax as well as regular income tax.
Q: What is the earliest that employees are able to receive any distributions from a 401(k) plan?-TOP A: Employer discretionary or matching contributions may be withdrawn if two years have passed since they were allocated under the plan, or if the participant has five years of plan participation. Employee after-tax contributions may be withdrawn at any time. Of course, distributions can only be made as provided under the terms of the Dian.
Q: Do I have to get an employee's permission to make a distribution from his or her account?-TOP A: Nonforfeitable (vested) benefits worth more than $5,000 ($3,500 before the Taxpayer Relief Act of 1997 (TRA '97); may not be distributed without the employee's consent before the employee reaches normal retirement age. Spousal consent also may be required. Amounts under $5,000, however, may be distributed without the employee's consent. Such distributions are subject to the 10-percent additional penalty and 20-percent withholding tax on early distributions and are includible in taxable income unless they are rolled over within 60 days.
Q: What happens if we terminate our 401(k) plan?-TOP A: If there is a partial or complete termination of the plan, then all accrued benefits (to the extent that they are funded) immediately become 100-percent vested (or nonforfeitable) and must be available for distribution to participants. For profit-sharing and stock bonus plans, this is also the case if there is a continuing lack of meaningful contributions to the plan. If the plan is terminated within a few years of its inception, it may be deemed "nonpermanent" and disqualified from favorable tax treatment. As an alternative, a plan may be "frozen." In addition, a distributior of elective contributions to a participant is not permitted if the employer establishes or maintains a successor plan.
Q: If Employer A is sold to Employer B, what happens to Employer A Is 401(k) plan?-TOP A: Distribution of elective contributions to all participants is permitted upon termination of a 401(k) plan resulting from the sale of "substantially all" (at least 85 percent) of the employer's assets. (Employer B may choose to continue the old plan.) This is also the case if an employer sells its interest in a subsidiary that employs the plan participant.
Q: Does an employer have to report an employee's 401(k) distribution to the IRS?-TOP A: Yes. All distributions from a 401(k) plan must be reported to the IRS on Form 1099-R, "Statement for Recipients of Total Distributions From Profit-Sharing, Retirement Plans, Individual Retirement Accounts, Etc." The employee must be provided with a copy of the 1099-R form as well.
Q: What happens if the ADP test for a plan year is not satisfied?-TOP A: If the ADP test for a plan year is not satisfied, the portion of the 401(k) plan attributable to elective contributions-and, most likely, the plan in its entirety-will no longer be qualified. The regulations, however, provide several mechanisms for correcting an ADP test that does not meet the requirements of the law. These mechanisms are as follows: 1. The employer makes QNECs or QMACs that are treated as elective contributions for purposes of the ADP test and that, when combined with elective contributions, cause the ADP test to be satisfied. 2. Excess contributions are re-characterized. 3. Excess contributions and allocable income are distributed. 4. The portion of the 401(k) plan attributable to elective contributions is restructured. A A plan may use any one or more of these correction methods.
Q: What is the tax treatment of corrective distributions to employees?-TOP A: The tax treatment of corrective distributions to employees depends on when the distribution is made. A corrective distribution made within 2 1/2 months after the end of the plan year is includible, to the extent at attributable to matching contributions, in the employee's gross income for the taxable year of the employee ending with or within the plan year in which the excess aggregate contribution arose. A corrective distribution made more than 2 1/2 months after the end of the plan year will be includible, to the extent attributable to matching contributions, in gross income for the taxable year in which distributed. The same rules apply to any income allocable to excess aggregate contributions. However, if the total amount of excess contributions and excess aggregate contributions for a plan year is less than $100, excess aggregate contributions and any allocated income will be includible in the year distributed regardless of when the corrective distribution is actually made.
Q: What happens if a plan fails to make a corrective distribution of excess aggregate contributions and allocable income?-TOP A: If a plan fails to make a corrective distribution during the 12month period following the plan year in which the excess aggregate contribution arose, the plan will be disqualified for that plan year and for all subsequent plan years in which the excess aggregate contribution remains in the plan. If a corrective distribution is made before the end of the 12-month period but more than 2 1/2 months after the end of the plan year, the employer will be subject to a 10 percent excise tax on the amount of the excess aggregate contributions. The excise tax can be avoided, however, if the employer makes QNECs enabling the plan to satisfy the ACP test. To be taken into account in performing the ACP test, QNECs must be made no later than 12 months after the plan year to which they relate. Thus, in 401(k) plans using the prior-year testing method in performing the ACP test, QNECs must be made no later than 12 months after the end of the prior plan year.
Q: Are safe harbor employer contributions and QNEC contributions (used to pass adp/acp tests) available for 401(k) loans?-TOP A: Yes
Q: Is there a special exemption for people who are 55+ and leave their job and want to take money from their 401(k) without penalty?- TOP A: Yes. Their 401(k) lump sum distribution is exempt from the 10% excise tax if it is made after the employee has separated from service and the separation from service occurs during or after the calendar year in the which employee attained age 55.
Q: Has the 20% back-up withholding been eliminated for hardship withdrawals? - TOP A: Yes.
Q: Does the 20% back-up withholding still apply to lump-sum distributions?- TOP A: Yes.
Q: Does the 20% back-up withholding still apply to all lump-sum distributions from a 401(k) plan?- TOP A: Yes.
Q: What is a lump sum distribution? TOP A: A lump sum distribution is a payment of the entire balance of a plan participant's 401(k) account within a single tax (calendar) year of the participant.
Q: What is five-year forward averaging? TOP A: Because lump sum distributions may push recipients into a higher
tax bracket for the year of the distribution, they are accorded special
tax treatment in the form of five-year forward
averaging. This method can be used to reduce the impact of the distribution
to the recipient in a single tax year by calculating the tax that would be
paid if the payment were broken up and spread over a five-year period.
Five-year forward averaging will not be available for distributions made
after 1999. This averaging option has been repealed by the Small Business Job
Protection Act of 1996, enacted Aug. 20, 1996. In addition, special 10-year
forward averaging rules apply to individuals who reached age 50 by
Q: What constitutes a disability? TOP A: Although the term "disability" is not defined in ERISA Section 401(k) or the IRS' Section 401(k) regulations, Code Section 72(m) defines the term as the inability "to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long continued and indefinite duration." Because this definition is rather restrictive, some employers apply a more liberal standard pertaining to "inability to perform normal work."
Q: How is a hardship defined under the hardship withdrawal rules? TOP A: In general, a hardship distribution can only be made on account of an
"immediate and heavy financial need" of the employee and must be
necessary to satisfy that need. (As a plan feature, hardship withdrawals are
optional.) IRS rules specify four expenses that would qualify: payment of
medical expenses, purchase of a principal residence, payment of tuition Q: What is a QDRO? TOP A: A qualified domestic relations order (QDRO) creates or recognizes an alternate payee's right to receive all or a portion of the benefits payable to a participant under a retirement plan. The order must be made according to a state domestic relations law and must meet minimum qualification requirements.
Q: What is a Stream-of-Payment QDRO? TOP A: A Stream-of-Payment QDRO provides that all or a portion of the participant's benefit otherwise payable to the participant is to be paid to an alternate payee. Stream-of-Payment QDROs are usually used when the QDRO awards an interest in alimony or child support payments.
Q: What is a Separate-Interest QDRO? TOP A: A Separate-Interest QDRO provides that the participant's accrued benefit under the plan is to be divided and a portion of the entire benefit is to be awarded to the alternate payee outright. Separate-Interest QDROs are common in defined contribution plans.
Q: What is the difference between participant loans and hardship withdrawals? TOP A: Although both allow employees access to their pre-tax contributions, only loans must be repaid. A loan can be made against the employee's entire account balance, and must be repaid within five years (or 10 years if used to purchase a principal residence). Interest that is not tax deductible must be charged.
Q: Are there limits on the amount that an employee is allowed to borrow? TOP A: Employees with $20,000 or less in their accounts may borrow up to $10,000 tax-free; employees with larger account balances may borrow half of their account balance tax-free, up to a maximum of $50,000 reduced by the highest account balance within the previous 12 months. Amounts borrowed in excess of those limits are considered taxable income. An employer may set a minimum loan amount up to $1,000.
Q: When are participant loans prohibited? TOP A: Loans made under a 401(k) plan must meet ERISA's prohibited transaction rules, which require that a 401(k) plan loan must be available to all participants reasonably equitably. Loans may not be made to owner or shareholder employees from plans maintained by unincorporated businesses and Subchapter S corporations, respectively. The rules also require that loans must be adequately secured and must charge a rate of interest commensurate to what lenders would charge. Loans that do not meet these criteria are prohibited.
Q: What happens if a loan is in default? TOP A: Neither the tax code nor ERISA provides specific guidelines as to whether (or when) a 401(k) employee loan must be declared in default. IRS proposed regulations under Section 72(p) provide guidance on when a loan will be treated as a distribution for tax purposes. DOL regulations say that a 401(k) plan can refrain from treating a loan that becomes taxable under Section 72(p) for failure of timely repayment as a "distribution" until the defaulting participant is otherwise entitled to receive his or her 401(k) benefits.
Q: What are guidelines for a 401(k) Loan? TOP A: A plan feature that allows participants to borrow money from their plan account and to pay it back through automatic after-tax payroll deduction. Generally, a loan is allowed for 50 % of the vested account balance, or $50,000 - whichever is less. If there is an outstanding loan balance, this amount is subtracted from the highest outstanding loan balance in the last 12 months. General loans can be financed for up to five years. If the money is used to purchase a primary residence, the loan can be extended up to 10 years. As long as participants repay the loan on time, they aren't subject to withholding taxes or penalties, as they would be if they withdrew the money from their account before retirement. Not all plans offer loans.
Q: Can a 401(k) be used as collateral for a independent loan? (In this question it is assumed the participant is NOT taking out a 401(k) loan, but instead "pledging" his/her 401(k) to a third-party lender). TOP A: No; by federal law a qualified retirement plan sanctioned by the IRS cannot be used a collateral for an independent third-party loan. Additional non-profit websites that include relevant unbiased information about 401k plans include: www.lifecycle401k.com
Q: If a participant's employment is terminated prior to the last day of the Plan Year, is the employee automatically entitled to either matching or profit sharing contributions? TOP A: No. If the plan document dictates, the employee may be required to work at least 1000 hours during the Plan Year, and/or be employed on the last day of the Plan Year to receive the contributions. (TAG)
Q: If an employee terminates employment, can he/she take a distribution of their 401(k) assets, even if the individual returns to the company as a legitimate independent contractor? TOP A: YES.
Q: What are the 3 basic exceptions to the 10% penalty for distributions from the 401(k) prior to age 59 1/2? TOP A:
Q: If a disabled employee has a certification of a Social Security Disability can he/she avoid the mandatory 20% backup withholding associated wit a distribution? -TOP A: No. Disabled employees who take distributions before 59 1/2 only avoid the 10% penalty. They are still subject to the 20% backup withholding.
Q: When an employee terminates employment and takes a lump sum distribution, what form is used to send with the 20% backup withholding which is sent to the IRS? How soon after the distribution is made must this payment be made? -TOP A: Federal Tax Deposit Form (Form 8109-B). Generally, income tax withheld from plan payments must be deposited with an authorized financial institution or a Federal Reserve bank or branch. A Federal tax deposit form must be included with each deposit. The timing requirement follows payroll withholding deposit rules. Q: What is a default IRA rollover? -TOP A: EGTRA creates a new rule for the distribution of terminated employee's 401(k) assets if they are between $1000 and $5000 and the employee does not elect a form of distribution. The employer can force the distribution, but must now open a "default IRA" for the proceeds to be rolled in to. I do not know how a default IRA can be set-up without the signature of the terminated employee.
Q: If an employer processes a distribution for a terminated employee, and in error rolls all of their accounts to another plan, forgetting to keep the non-vested employer contributions, can the non-vested amount be retrieved within a certain time period? -TOP A: The plan fiduciary or trustee is required to seek repayment if a terminated participant is paid more than their vested amount. There is not a prescribed time frame, but, as in the case with most corrections, the sooner the better.
Q: Is it permissible to change the interest rate on a 401(k) loan? Example: an employee took out a loan when prime was high. The employer would like to now lower that rate to reflect the current market rate. -TOP A: Yes, participant loans may be refinanced to a lower interest rate if the loan policy permits refinancing, but the 401(k) Easy loan pac indicates that the loan interest rate shall be fixed, so it would not be allowed within 401(k) Easy. rrp
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