A feature of many 401(k) plans (as well as 403(b) and 457 plans) is the ability of the plan participant to take a loan from the plan to assist in meeting near term goals. This is particularly effective where there is no other desirable source of funds and the participant has stable employment. Such a loan can be a real benefit in times like the present where the pandemic has caused stress and change from what used to be normal.
The primary reason for considering this source of funding is the ability to avoid having the loan treated as a taxable distribution from the plan and so not subject to either regular income taxation or to the ten percent penalty assessed on early distributions for those younger than age 59½. Of course, in order to enjoy the benefits of such a loan, it is necessary for the plan participant to repay the loan to the plan, typically within five years while making regular payments on a quarterly basis.
The rules governing the loans are also limiting in terms of the amount which may be withdrawn from the plan as a loan. The maximum amount is $50,000 and the loan cannot exceed 50% of the value of the plan account or $10,000, whichever is less. This means that large plan balances will not be usable to fund large loans but smaller amounts – more in keeping with most short term cash needs – can be funded to the extent noted above.
The biggest risk to a plan participant is, not surprisingly, job loss. If the employment is terminated, then the outstanding balance of the loan generally must be repaid to the plan. Prior law required this repayment to occur within 60 days if the participant wished to avoid income tax and penalties on the unpaid amount. Current law now extends that time frame to the date of the tax filing deadline for the year in which the termination of employment (or of the plan itself) occurred. There are other situations in which the participant may be subject to taxation and penalties, such as where the installment payments on the loan are not made timely. Care should be taken to fulfill all the requirements of the loan for this technique to prove useful.