10% penalty

How to Borrow Money from a 401(k)

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401k loanOne benefit of being a participant in a qualified retirement plan (e.g., 401(k) or profit sharing plan, but not a SIMPLE or SEP) is the ability to borrow money from the qualified plan.  The loan process is usually quick, the funds can be borrowed for any reason, it won’t affect the participant’s credit rating, and can cost less than a bank loan.  Additionally, the interest the participant pays on the loan is essentially paid back into the participant’s plan account (i.e., the participant is paying interest to herself).

It is important that the loan follow certain rules or the amount loaned will be treated as a taxable distribution and be subject to the 10% early withdrawal penalty.

The Maximum Loan Amount Requirement

The loan amount cannot exceed the lesser of:

  • $50,000 or
  • One-half of the present value of the participant’s nonforfeitable accrued benefit under the plan

If the plan meets certain requirements, a loan of up to $10,000 is allowed even if $10,000 is greater than ½ of the participant’s nonforfeitable accrued benefit.

A participant can have more than one outstanding loan at a time.  However, any new loan, when added to the outstanding balance of all of the participant’s plan loans, cannot exceed the plan maximum amount.

The Term Requirement

The loan must generally be repaid within five years with substantially level amortization, with payments made not less frequently than quarterly, over the term of the loan.  The five-year term requirement does not apply when the plan loan is used to buy a principal residence for the participant.

The level amortization is not required if the participant is on a leave of absence not lasting more than one year (longer, if for military service) and either (1) is not receiving pay or (2) is receiving pay at a lower rate than the required installments under the plan loan.  Even though the level amortization requirement is avoided, the loan must still be repaid within the five years.

Documentation Requirement

The loan must be evidenced by a legally enforceable written agreement with terms that demonstrate compliance with the requirements for non-distribution treatment, specifying the amount and date of the loan, and the repayment schedule.

Is the Interest Deductible?

Probably not.  There are three situations where interest is definitely not deductible.  The first is where the loan is made to a key employee (a 5% owner of the company or an officer making more than $170,000 for 2016).  The second situation is where the loan is secured by amounts attributable to the employee’s contribution amounts to the plan.  The final situation is where the loan is used for education.  Even if none of these three rules bar the interest deduction, the plan loan must meet specific statutory rules to be deductible (e.g., business loans, loans secured by a residence, etc.)

To see how this applies to you, give us a call at 248-538-5331.

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Avoid the 10% Penalty on Early Retirement Distributions

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penaltyThere is a penalty for receiving distributions from retirement plans (such as qualified plans and IRAs) prior to reaching age 59½.   The penalty is 10% of the amount withdrawn, and is in addition to federal, state, and local income taxes.  Fortunately, there are situations where the 10% will not be imposed.  Unfortunately, even if the 10% penalty is avoided, the taxpayer will still be liable for income taxes on the distribution.  There are exceptions that apply to both qualified plans and IRAs, exceptions that apply only to qualified plans, and exceptions that apply only to IRAs.

Exceptions to the 10% Early Withdrawal Penalty for Both Qualified Plans and IRAs

Distributions made on or after the account owner’s death

Distributions attributable to the account owner becoming disabled

Distributions that are part of a series of substantially equal payments (an annuity) for the life of the account owner or the joint lives of the account owner and a designated beneficiary.

Basically, if the retirement account is annuitized over the life of the account owner, the account owner will not be subject to the 10% penalty.  While the annuity is calculated over the life expectancy of the account owner, the annuity will only have to last through the later of (1) five years after the annuity begins or (2) the date the account owner reaches age 59½.  For qualified plans, this exception only applies after the account owner separates from service.

Distributions to the extent of deductible medical expenses

If the account owner paid medical expenses during the year and the medical expenses exceeded 10% of AGI (7.5% of AGI for taxpayers age 65 or older through 2016), the distributions equal to the excess of medical expenses over the 10% of AGI won’t be subject to the penalty.

Distributions made on account of an IRS levy on the retirement plan

If the IRS directly levies a retirement account, the levy (distribution) will not be subject to the penalty.  This exception does not apply if the account owner receives a distribution in order to pay the IRS balance—the IRS must directly levy the account.

Qualified reservist distributions

There is an exception for distributions to reservists (Army National Guard, Army Reserve, etc.) who are ordered or called to active duty for a period of more than 179 days or for an indefinite period, and where the distribution was made no earlier than the date of the order or call to active duty and no later than the close of the active duty period.

Exceptions to the 10% Early Withdrawal Penalty for Only Qualified Plans

Made to an employee after separation from service after reaching age 55.

This exception only applies if the account owner separates from service (quits, gets fired, etc.) after reaching age 55.  It would not apply, for example, if the employee separates from service at age 54 and receives a distribution after reaching age 55.

Paid to an alternate payee under a Qualified Domestic Relations Order.

Qualified plans can be divided in divorce.  When the spouse of the account owner receives a portion of the qualified plan, the spouse can receive distributions from the qualified plan without being subject to the 10% penalty.  The account owner (employee) will still be subject to the 10% penalty on premature distributions he/she receives.

Exceptions to the 10% Early Withdrawal Penalty for Only IRAs

For first time homebuyers (up to $10,000)

First time homebuyer doesn’t literally mean first timeFirst time homebuyer is defined as not having an ownership interest in a principal residence during the two year period ending on the date the new home is acquired

Used to pay higher education expenses

Distributions equal to medical insurance premiums for workers who have received federal or state unemployment benefits for 12 consecutive weeks.

Under this rule, the 10% of AGI limitation does not apply.

If you have questions on how this relief applies to you, give us a call at 248-538-5331
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How to Avoid the 10% Penalty on Early Retirement Account Distributions

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One issue with investing money in a 401k or IRA is that you generally cannot access the funds until you reach age 59½.  If you withdraw funds from these retirement accounts before that age, you will be subject to a 10% penalty on the amount distributed.  This penalty is in addition to the federal and state income taxes you’ll pay on the distribution.

Fortunately, the IRS will waive the 10% penalty in certain circumstances.  However, even if you meet one of these exceptions, you’ll still have to pay federal and state income taxes on the distribution even if the 10% penalty is waived.

The exceptions are:

  • Distributed funds that are rolled over into an IRA or other qualified plan
  • Distributions upon death or disability of the account owner
  • Distributions that are part of a series of substantially equal periods payments over the life of the account owner or the joint lives of the participant and beneficiary
    • Translated into English: when you have a balance in a retirement account, you can calculate an annuity based on the amount in the account payable over your life expectancy (there are a few ways to calculate this annuity).  These annuity payments are exempt from the 10% penalty.  The annuity has to last through the later of:
      • When the account owner turns 59½
      • Five years after the date annuity payments began
  • Distributions after the participant’s separation from service (i.e., quitting/laid off/fired), provided the separation from service occurred during or after the year the participant reached age 55 (or age 50 for government plans to a retired police officer, firefighter, or emergency medical services provider).
    • This exception applies only to qualified plans, it does NOT apply to IRAs
  • Distributions to a former spouse under a Qualified Domestic Relations Order (QDRO)
    • Pension benefits are often divided during divorce.  To properly comply with pension plan rules, retirement accounts can only be split up pursuant to a QDRO.  Otherwise, the plan will have made a disallowed distribution to a nonparticipant.  This could jeopardize the tax-advantaged status of the pension plan.
    • Once a retirement account has been divided pursuant to a QDRO, the nonparticipant spouse can receive distributions without incurring the 10% penalty.  However, the nonparticipant spouse is still subject to the pension plan rules and isn’t entitled to any type or form of benefits that aren’t available in the plan.
    • IRAs do not require QDROs to be divided in divorce.  The division of the IRA does not cause a distribution; however, amounts withdrawn from the IRAs by either spouse will not be exempt from the 10% penalty if it is a disqualifying distribution.
  • Distributions to the extent of deductible medical expenses
    • Medical expenses are reduced by 7.5% of adjusted gross income to arrive at deductible medical expenses.  Early distributions equal to this amount can be distributed free of penalty.
  • Distributions made on account of the IRS’ levy of retirement accounts

The following exceptions apply only for IRAs:

  • Distributions equal to medical insurance premiums for workers who have received federal or state unemployment benefits for 12 consecutive weeks.  The reduction for 7.5% of adjusted gross income does not apply.
  • Distributions used to pay for qualified higher education expenses (college) for the account owner, owner’s spouse or child/grandchild.
  • Distributions up to $10,000 for first time homebuyers.
    • “First time” doesn’t literally mean “first time.”
    • First time homebuyer is defined as not having an ownership interest in a principal residence during the two year period ending on the date the new home is acquired

Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230.
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