Borrowing Money From Employee Plans

Employers and employees should be reminded that only qualified plans, such as profit-sharing, 401(k) and money purchase plans may allow participants to borrow money from their accounts, and only if the plan document specifically permits such loans to be made.  IRA-based plans, such as SEPs, SIMPLE IRAs and SARSEPs, and traditional and Roth IRAs cannot provide loans to participants.

The amount participants may borrow is limited to the lesser of $50,000 or 50% of their vested account balance (the amount that actually belongs to a participant, even if he terminates employment).  Loans need to be repaid back to the account at least quarterly, over a period not exceeding five years.  An exception to the five-year rule applies for loans taken out for the purchase of a participant's principal residence.

Loans that initially don't meet the Code requirements (because they aren't limited to 50% of the vested account balance or they exceed $50,000) are treated as a distribution when the loan is made and are taxed accordingly.  Missing payments cause the loan to go into default and therefore be taxed as a distribution.

The number one taxability issue with plan loans occurs when a participant terminates employment with an outstanding loan balance.  In this situation, plans usually offset the distribution of the participant's account by the amount of the outstanding loan balance.  For tax purposes, the amount of the distribution includes the loan balance at the time of the offset.  If the participant wants to roll over his entire benefit, then he must come up with money that represents the loan offset as well as money to cover the 20% mandatory federal income tax withholding that applies to the full amount, including the loan offset.  The 10% additional early distribution tax also applies if the participant is under age 59-1/2 unless an exception to the early withdrawal tax applies.

Borrowing by owner-employees - An owner-employee may borrow from the company's plan but must follow the same rules that apply to other participants.  It must be a formal loan meeting all of the loan requirements dealing with amounts and repayment; otherwise, it may be tagged as a prohibited transaction.

In tough economic times, employers may be tempted to dip into plan assets just to tide it over, to meet payroll or pay other bills and then pay it back later.  This is strictly prohibited as employers are never allowed to dip into plan assets for any reason.  Another “no no” is when an employer withholds salary deferrals from his employees' pay with the intention of depositing the money in its 401(k) or SIMPLE IRA plan, but doesn't actually do it.  The employer “borrows” the money, maybe to cover payroll, or rent, thinking that it won't hurt to wait a few weeks until the withheld salary deferrals are deposited into the plan's funding vehicle.  The Department of Labor looks very harshly on this fiduciary violation.  The money must be deposited in the trust or IRAs as soon as the money can be reasonably segregated from the employer's assets.

Please call this office for additional information.

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