The uncertain economy has left many people looking for money in new places. One idea that may cross your mind is taking out a loan from your 401(k). Indeed, those are your dollars in that account and you”™re free to use them as you please ”“ within certain limits. But there are serious tax-related issues to consider.
The basic rules
Before we get into those issues, let”™s look at the basic rules of 401(k) loans. First, you”™ll have to check whether your plan even allows loans. Most do, but that”™s no guarantee.
If your 401(k) does allow loans, the maximum amount you can borrow is 50 percent of your vested balance up to $50,000. And the terms of your loan can”™t go more than five years unless you”™re using the money to buy a home (if it will be your “principal residence”). In the case of a home purchase, you can have up to 30 years to pay back the money.
To officially execute the loan, you”™ll need to sign a promissory note as well as a form authorizing a payroll deduction repayment plan. In addition, your employer will likely prepare an amortization schedule and provide a list of loan terms that includes the loan amount, your repayment terms, the loan”™s length and the interest rate.
Deemed distributions
Should you fail to abide by the terms of your 401(k) loan or the statutory requirements governing these transactions, the IRS will treat the amount you borrowed as a “deemed distribution” ”“ a taxable event. That means you”™ll be taxed on the loan amount at your current income tax rate.
The good news is that your employer may have built a “cure period” into its loan program that enables borrowers to fix their mistakes before taking a big tax hit. The length of a cure period, however, can”™t exceed one calendar quarter following the quarter in which the loan violation took place. So check with your benefits rep about this.
Indeed, employers can build many stipulations into their 401(k) plans that you should know about before deciding to pull the trigger on such a loan. Your current employer may not handle it the same way a previous one did.
Also bear in mind that you may have more to fear than taxes. If you”™re younger than 59½ and you fail to repay your loan within the allotted period, you may face a 10 percent early withdrawal penalty. And, yes, that”™s in addition to any income tax liability.
Hardship withdrawals
If times are particularly tough, you may not need to take out a 401(k) loan at all ”“you could be eligible to make a “hardship withdrawal.” Your employer”™s plan may, for instance, permit such withdrawals for medical care, college tuition, funerals and home-related expenses to avoid eviction or foreclosure.
Naturally, hardship withdrawals aren”™t necessarily easy to qualify for. Expect to be asked for proof that you”™ve gone through any of your available resources. Plus, your withdrawal amounts will still be subject to your current income tax rate and, aside from some medical expenses, you”™ll have to pay that 10 percent early withdrawal penalty (again assuming you”™re under age 59½).
So what”™s the advantage of a hardship withdrawal? You don”™t need to pay back the money. Just bear in mind that, along with the taxes you pay currently, you”™re giving up future tax-deferred earnings on the withdrawal amount.
When times get tough, cutting back on spending and increasing savings are generally the two best first steps. But a 401(k) loan can serve a useful purpose when time is of the essence. To avoid a nasty surprise, however, be sure you”™re aware of the tax implications of such a loan. And, just as important, be sure you have a sound plan for paying it back.
This has been a general discussion and is not intended as specific advice.
Norman G. Grill Jr. is managing partner of Grill & Partners L.L.C., certified public accountants and consultants with offices in Fairfield and Greenwich. Reach him at N.Grill@GRILL1.com.
