Tap 401(k) for tax-free loan
Although your 401(k) plan is designed to grow retirement savings, it can potentially be tapped for instant cash if you have nowhere else to turn.
Strategy: Borrow from your 401(k), when necessary and if your plan allows it. If you stay within the tax law boundaries, you won’t owe any tax or penalty. In fact, because you must pay yourself back—with interest—you’ll be reaping extra benefits.
Here’s the whole story: Typically, a 401(k) plan permits employees to make hardship withdrawals. However, this is allowed only if you have an immediate and heavy financial need and lack other resources. Also, hardship distributions are subject to income tax and a 10% early withdrawal penalty unless they qualify for a penalty exception. Conversely, if your 401(k) plan includes a loan feature, you can sidestep dire tax consequences. You don’t owe any tax on a loan if the borrowed amount doesn’t exceed the lesser of $50,000 or 50% of the present value of the employee’s no forfeitable accrued benefit under the plan. However, a loan up to $10,000 is permissible, even if it is more than half of the employee’s accrued benefit.
8 main requirements If your company’s 401(k) plan doesn’t have a loan feature, it could be amended to provide this option. The following eight requirements must be met under the regulations.
1. Availability. Loans must be available to all participants on a reasonably equivalent basis. In other words, loans must be available without regard to race, color, religion, sex or national origin. Also, in considering whether to make loans, plans can consider only such factors as commercial lenders would consider, such as creditworthiness and financial need.
2. Nondiscrimination rules. Loans can’t be made available to highly compensated employees (HCEs), officers or shareholders in amounts greater than those made available to other employees. This condition will not be violated merely because the loans do not exceed a maximum amount or a maximum percentage of a participant’s vested account balance.
3. Specific plan provisions. Loans must be made under specific provisions contained in the plan document. The plan must state the procedure for applying for loans, the basis on which loans are approved or denied, the limitations on types and amounts of loans, the procedure for determining a reasonable rate of interest, the collateral that may secure loans and how the plan will deal with defaults.
4. Length of term. Loans generally must be repayable within five years (see box).
5. Reasonable rate of interest. A loan must bear a reasonable rate of interest. This test is met if the rate charged is like what banks or other commercial lenders would charge under similar circumstances.
6. Adequate security. Loans must be adequately secured. In other words, you need more than just a promise to pay—there must be security that could be sold so that the plan would suffer no loss of interest or principal. The regulations allow plans to permit the participant to use up to one-half of his or her account balance to secure loans. So if loans are limited to 50% of a participant’s account balance, the plan can avoid the need to acquire additional security.
7. Frequency of payments. Payments must be made in quarterly installments or at more frequent intervals (e.g., monthly, weekly, etc.).
8. Amortization. There must be level amortization.
Tip: Rememb er that 401(k) plan loans should be viewed as a last resort only.
Key exception for home purchase. According to the prevailing regulations, a 401(k) loan generally must be repaid within five years. But you may qualify for a special exception. Strategy: Use the loan proceeds to buy a home. The usual five-year requirement doesn’t apply to a loan if the money is used to buy a home that is your principal residence. Thus, you may take as long to repay the loan as needed. This provides 401(k) participants with some extra flexibility. However, a refinancing generally doesn’t qualify as a principal residence plan loan for this purpose. Tip: This exception does not apply to a loan to buy a vacation home.