One 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.
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.
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.