Plan Loans & What Can go Wrong

Plan loans can be a very enticing way for employers to offer a plan and yet allow employees to feel like they aren’t locking up their money for a lifetime. These loans have benefits as well as they are generally easier to obtain than other bank financing, are initially tax-free and penalty-free if all conditions are met, have lower interest rates than loans available elsewhere, and require payments back to the individual (vs. a bank).

If a plan offers loans, they generally allow you to take out 50% of your vested balance up to a maximum of $50,000. But what happens if you default on the loan? When employees leave an employer, they typically have to cut a check for the outstanding balance on the loan or it will go into default.

If a participant is under 59 1/2, they frequently pay ordinary income on the loan balance as well as a 10% penalty. If they took a loan, it is fairly common that they don’t have the means to pay back the loan if they were to leave their employer. Sometimes this happens because a new opportunity arises but other times it happens due to lay-offs, leaving to care for a loved one, or other circumstances beyond ones control.

With this in mind, what is the best way to approach loans? Frequently we recommend these only as a last resort due to the potential tax ramifications in a default. An employee should also seek out tax advice prior to defaulting on a loan or refinancing a plan loan (if that option exists). There are many hang-ups that can occur that an HR department is not going to be equipped to handle. Lastly, know the difference between a deemed distribution and a plan loan offset. A loan offset amount can be rolled over to an IRA or another employer plan by April 15th of the year after the offset occurs (or Oct. 15th if an extension is filed). A deemed distribution is taxable and cannot be rolled over. #401k #403b #QPRetirement