EXECUTIVE
SUMMARY

 
  • Loans from qualified plans will be considered taxable distributions from the plans unless certain requirements are met. The maximum plan loan an employee may take is $50,000, but the loan amount may be limited based on the amount of previous plan loans taken by the employee.
  • In general, a qualified plan loan is better from an overall perspective than an outside loan if the growth rate of the plan assets is lower than the interest rate on the plan loan and the interest rate on an equivalent outside loan.
  • In general, an outside loan is better if the growth rate of the plan assets is greater than the interest rate on the outside loan and the interest rate on an equivalent plan loan. However, if the growth rate on the plan assets is greater than the interest rate on a plan loan but less than the interest rate on an outside loan, a plan loan will generally be better, but possibly not significantly better.
  • Whether the interest on the prospective loan will be deductible does not significantly affect the determination of whether a plan loan or an outside loan is more desirable. However, if the interest on an outside loan is deductible, but the interest on a plan loan is not (e.g., because the loan is to a key employee), the plan loan becomes less desirable.
  • A downside to plan loans is that they may terminate on the occurrence of certain events, such as a severance from employment, that will not affect an outside loan.
  • Taking an unneeded plan loan to boost the growth rate of an employee's qualified plan account could possibly result in a prohibited transaction subject to substantial penalties.

This article analyzes how an employee should decide whether to borrow from his or her qualified retirement plan. This analysis first requires a little background on plan loans.1 Generally, a loan to an employee from a qualified plan is taxable as a plan distribution and is also subject to the 10% additional tax on premature distributions (if none of the statutory exceptions apply).2 Nevertheless, an employee may treat certain five-year loans, or certain loans used to purchase a principal residence, as true loans that are not taxable as plan distributions.3

To qualify as a true loan, a loan must be enforceable, in writing, and nondiscriminatory. It must provide for a reasonable rate of interest and substantially equal repayments quarterly or more frequently. It cannot be payable on demand.4Nevertheless, even a loan that meets those requirements is taxable as a distribution to the extent the loan amount exceeds the smallest of the following.5

  1. $50,000 less previous plan loans unpaid immediately before the new loan was issued;6
  2. $50,000 less the highest outstanding loan balance during the one-year period immediately preceding the new loan's issuance;7 or
  3. An amount equal to (a) one-half of the value of the nonforfeitable interest in the plan, less (b) the amount of previous plan loans unpaid immediately before the new loan was issued. (However, if the nonforfeitable interest in the plan is less than $20,000, the limitation is instead $10,000 less previous plan loans unpaid immediately before the new loan was issued.)8

In applying items (1) through (3) above, an employee must treat as a single plan all of the employer's qualified retirement plans (and formerly qualifying plans), including all plans of certain closely related employers. If the employer is a governmental entity, the employee must treat all the employer's plans as a single plan (whether or not they are qualified retirement plans).9











































Plan loans as alternatives to loans from outside lenders

An employee about to borrow money for a financial need might consider a loan from his or her qualified defined contribution plan (hereafter "qualified plan") as a possible alternative to a loan from a commercial or other outside lender. The interest rate on the plan loan is usually lower than on a commercial loan, and the interest paid on the plan loan goes back into the employee's account. However, the employee must also consider the effect of liquidating some of the plan assets to fund the plan loan.

Example 1: An employee must borrow $50,000 for the purchase of an automobile for his personal use. He can borrow that amount at 7% interest from a third-party lender, with monthly repayments of $990 over a five-year term. Alternatively, he may borrow that amount at 5% interest from the $100,000 balance in his qualified plan. He must repay the plan loan by making monthly payments of $944 over the five-year term. Assume the loan from the plan will satisfy the requirements described above for a qualified plan loan.

Also assume the balance of the employee's account in his qualified plan grows at an average annual rate of 3%. Under these facts, the employee would normally choose to borrow from the plan. The employee will pay less interest on the plan loan because of its lower interest rate. In addition, the balance of the employee's account in his plan should grow faster because the loan interest rate is higher than the plan growth rate of 3%

 

EXECUTIVE
SUMMARY

 
  • Loans from qualified plans will be considered taxable distributions from the plans unless certain requirements are met. The maximum plan loan an employee may take is $50,000, but the loan amount may be limited based on the amount of previous plan loans taken by the employee.
  • In general, a qualified plan loan is better from an overall perspective than an outside loan if the growth rate of the plan assets is lower than the interest rate on the plan loan and the interest rate on an equivalent outside loan.
  • In general, an outside loan is better if the growth rate of the plan assets is greater than the interest rate on the outside loan and the interest rate on an equivalent plan loan. However, if the growth rate on the plan assets is greater than the interest rate on a plan loan but less than the interest rate on an outside loan, a plan loan will generally be better, but possibly not significantly better.
  • Whether the interest on the prospective loan will be deductible does not significantly affect the determination of whether a plan loan or an outside loan is more desirable. However, if the interest on an outside loan is deductible, but the interest on a plan loan is not (e.g., because the loan is to a key employee), the plan loan becomes less desirable.
  • A downside to plan loans is that they may terminate on the occurrence of certain events, such as a severance from employment, that will not affect an outside loan.
  • Taking an unneeded plan loan to boost the growth rate of an employee's qualified plan account could possibly result in a prohibited transaction subject to substantial penalties.

This article analyzes how an employee should decide whether to borrow from his or her qualified retirement plan. This analysis first requires a little background on plan loans.1 Generally, a loan to an employee from a qualified plan is taxable as a plan distribution and is also subject to the 10% additional tax on premature distributions (if none of the statutory exceptions apply).2 Nevertheless, an employee may treat certain five-year loans, or certain loans used to purchase a principal residence, as true loans that are not taxable as plan distributions.3

To qualify as a true loan, a loan must be enforceable, in writing, and nondiscriminatory. It must provide for a reasonable rate of interest and substantially equal repayments quarterly or more frequently. It cannot be payable on demand.4Nevertheless, even a loan that meets those requirements is taxable as a distribution to the extent the loan amount exceeds the smallest of the following.5

  1. $50,000 less previous plan loans unpaid immediately before the new loan was issued;6
  2. $50,000 less the highest outstanding loan balance during the one-year period immediately preceding the new loan's issuance;7 or
  3. An amount equal to (a) one-half of the value of the nonforfeitable interest in the plan, less (b) the amount of previous plan loans unpaid immediately before the new loan was issued. (However, if the nonforfeitable interest in the plan is less than $20,000, the limitation is instead $10,000 less previous plan loans unpaid immediately before the new loan was issued.)8

In applying items (1) through (3) above, an employee must treat as a single plan all of the employer's qualified retirement plans (and formerly qualifying plans), including all plans of certain closely related employers. If the employer is a governmental entity, the employee must treat all the employer's plans as a single plan (whether or not they are qualified retirement plans).9

Plan loans as alternatives to loans from outside lenders

An employee about to borrow money for a financial need might consider a loan from his or her qualified defined contribution plan (hereafter "qualified plan") as a possible alternative to a loan from a commercial or other outside lender. The interest rate on the plan loan is usually lower than on a commercial loan, and the interest paid on the plan loan goes back into the employee's account. However, the employee must also consider the effect of liquidating some of the plan assets to fund the plan loan.

Example 1: An employee must borrow $50,000 for the purchase of an automobile for his personal use. He can borrow that amount at 7% interest from a third-party lender, with monthly repayments of $990 over a five-year term. Alternatively, he may borrow that amount at 5% interest from the $100,000 balance in his qualified plan. He must repay the plan loan by making monthly payments of $944 over the five-year term. Assume the loan from the plan will satisfy the requirements described above for a qualified plan loan.

Also assume the balance of the employee's account in his qualified plan grows at an average annual rate of 3%. Under these facts, the employee would normally choose to borrow from the plan. The employee will pay less interest on the plan loan because of its lower interest rate. In addition, the balance of the employee's account in his plan should grow faster because the loan interest rate is higher than the plan growth rate of 3%

​BORROWING FROM A QUALIFIED RETIREMENT PLAN

INCOME TAX PREPATIOON

Copyright ©​ Daniel Cullinane CPA.

CONTACT US

Daniel Cullinane CPA

25 Plaza 5 25th fl Jersey City NJ                                          phone 732-516-1648 fax 732-516-9778

MBA Taxation

Daniel Cullinane CPA

2500 Plaza 5 25th fl  Jersey City NJ 07311                                                          phone 732-516-1648  fax 732-516-9778

                 MBA TAXATION