Want to borrow money from your retirement plan? Not so fast. Retirement plan loans can be a viable way to get money in a crunch, but you need to follow the rules about repaying them. If you don’t, it could lead to unfavorable tax consequences, as two taxpayers recently learned the hard way in U.S. Tax Court.
A participant in an employer-sponsored qualified retirement plan can borrow money from the plan if it allows loans. The loan amount generally can’t exceed the lesser of:
- $50,000, or
- 50% of the employee’s vested account balance or accrued benefit.
However, a loan of up to $10,000 is allowed even if it exceeds the 50% limit. Plan loans must call for substantially level payments that are made at least quarterly and they generally must be repaid within five years.
However, there’s an exception for principal residence loans; these can have longer repayment periods. These loans must be used to acquire a home that will be used as the plan participant’s principal residence. Like other types of retirement plan loans, principal residence loans must be repaid in substantially level amounts that are paid at least quarterly.
The Dark Side: Loan Defaults
If a plan participant (borrower) fails to make a plan loan payment by the due date or within the specified grace period, the failure can trigger a loan default and a deemed taxable distribution equal to the entire amount of the outstanding loan balance. In other words, the loan is extinguished, but it’s deemed to be paid off with the taxable distribution from the plan. This treatment would increase your taxable income – and your tax liability for the year.
To add insult to injury, an early qualified plan distribution, including a deemed distribution caused by a plan loan default, can also trigger a 10% early distribution penalty tax depending on your age. The 10% penalty applies if the plan participant (borrower) is under age 59-1/2 unless an exception is available.
In two recent decisions, the U.S. Tax Court sided with the IRS, by determining that taxpayers who failed to make timely repayments on loans from their employer’s qualified retirement plans were considered to have defaulted on the loans. Therefore, they were deemed to have received taxable distributions from the plans, which triggered a federal income tax hit and, because the taxpayers were under age 59-1/2, the 10% penalty tax on early retirement plan distributions.
In the first recent decision — Louelia Salomon Frias v. Commissioner (TC Memo 2017-139) — the court concluded that a 401(k) plan loan, which the taxpayer took before she went on leave, was a taxable distribution when she failed to begin making repayments on time and failed to make the repayments in substantially level amounts. It didn’t matter that the taxpayer’s employer disregarded her instructions to deduct loan repayments from her paychecks during the period she was on leave or that she eventually repaid the loan.
In the second case — Gregory J. Gowen v. Commissioner (TC Summary Opinion 2017-57) — the taxpayer defaulted on his 401(k) plan loan after he lost his job. After an audit, the IRS determined the default was a taxable distribution in the year the plan’s grace period for repayment expired. A plan loan’s grace period can’t continue beyond the last day of the calendar quarter following the calendar quarter in which the required installment payment was due. The court agreed with the IRS on all points.
Could a Retirement Plan Loan Work for You?
Taking out a retirement plan loan can make sense in the right circumstances. But it doesn’t take much to be considered in default under the tax rules – and defaulting on plan loans can trigger dire tax consequences. If you have questions or want more information about retirement plan loans, contact your tax advisor.