7.16 Restrictions on Loans From Company Plans
Within limits, you may receive a loan from a qualified company plan, annuity plan, 403(b) plan, or government plan without triggering tax consequences. The maximum loan you can receive without tax is the lesser of 50% of your vested account balance or $50,000, but the $50,000 limit is subject to reductions where there are other loans outstanding; see below. Loans must be repayable within five years, unless they are used for buying your principal residence. Loans that do not meet these guidelines are treated as taxable distributions from the plan. If the plan treats a loan as a taxable distribution, you should receive a Form 1099-R with Code L marked in Box 7.
If your vested accrued benefit is $20,000 or less, you are not taxed if the loan, when added to other outstanding loans from all plans of the employer, is $10,000 or less. However, as a practical matter, your maximum loan may not exceed 50% of your vested account balance because of a Labor Department rule that allows only up to 50% of the vested balance to be used as loan security. Loans in excess of the 50% cap are allowed only if additional collateral is provided.
If your vested accrued benefit exceeds $20,000, then the maximum tax-free loan depends on whether you borrowed from any employer plan within the one-year period ending on the day before the date of the new loan. If you did not borrow within the year, you are not taxed on a loan that does not exceed the lesser of $50,000 or 50% of the vested benefit.
If there were loans within the one-year period, the $50,000 limit must be further reduced. The loan, when added to the outstanding loan balance, may not exceed $50,000 less the excess of (1) the highest outstanding loan balance during the one-year period (ending the day before the new loan) over (2) the outstanding balance on the date of the new loan. This reduced $50,000 limit applies where it is less than 50% of the vested benefit; if 50% of the vested benefit was the smaller amount, that would be the maximum tax-free loan.
Caution
Repayment period.
Generally, loans within the previously discussed limits must be repayable within five years to avoid being treated as a taxable distribution. However, if you use the loan to purchase a principal residence for yourself, the repayment period may be longer than five years; any reasonable period is allowed. This exception does not apply if the plan loan is used to improve your existing principal residence, to buy a second home, or to finance the purchase of a home or home improvements for other family members; such loans are subject to the five-year repayment rule.
Level loan amortization required.
To avoid tax consequences on a plan loan, you must be required to repay using a level amortization schedule, with payments at least quarterly. According to Congressional committee reports, you may accelerate repayment, and the employer may use a variable interest rate and require full repayment if you leave the company.
Giving a demand note does not satisfy the repayment requirements. The IRS and Tax Court held the entire amount of an employee’s loan to be a taxable distribution since his demand loan did not require level amortization of principal and interest with at least quarterly payments. It did not matter that the employee had paid interest quarterly and actually repaid the loan within five years.
If required installments are not made, the entire loan balance must be treated as a “deemed distribution” from the plan under IRS regulations. However, the IRS allows the plan administrator to permit a grace period of up to one calendar quarter. If the missed installment is not paid by the end of the grace period, there is at that time a deemed distribution in the amount of the outstanding loan balance.
Under IRS regulations, loan repayments may be suspended for up to one year (or longer if you are in the uniformed services) if you take a leave of absence during which you are paid less than the installments due. However, the installments after the leave must at least equal the original required amount and the loan must be repaid by the end of the allowable repayment period (five years if not used to buy a principal residence). For example, on July 1, 2008, when his vested account balance is $80,000, Joe Smith takes out a $40,000 non–principal residence loan, to be repaid with interest in level monthly installments of $825 over five years. He makes nine payments and then takes a year of unpaid leave. When he returns to work he can either increase his monthly payment to make up for the missed payments or resume paying $825 a month and on June 30, 2013, repay the entire balance owed in a lump sum.
If loan payments are suspended while you are serving in the uniformed services, the loan payments must resume upon returning to work and the loan repayment period (five years from the date of the loan unless the loan was used to buy your principal residence) is extended by the period of suspension.
Spousal consent generally required to get a loan.
All plans subject to the joint and survivor rules (7.11) must require spousal consent in order to use your account balance as security for the loan in case you default. Check with your plan administrator for consent requirements.
Interest deduction limitations.
If you want to borrow from your account to buy a first or second residence and you are not a “key” employee (3.4), you can generally obtain a full interest deduction by using the residence as collateral for the loan (15.2). Your account balance may not be used to secure the loan. Key employees are not allowed any interest deduction for plan loans.
If you use a plan loan for investment purposes and are not a key employee, and the loan is not secured by your elective deferrals (or allocable income) to a 401(k) plan or tax-sheltered annuity, the loan account interest is deductible up to investment income (15.10). Interest on loans used for personal purposes is not deductible, unless your residence is the security for the loan.