In Retirement News for Employers (Winter 2012), the Internal Revenue Service (the “IRS”) provides guidance on taking loans from a retirement plan. The IRS said that, before you decide to take a loan from your retirement plan, there are a few rules you need to know.
Does your retirement plan allow loans? The law does not allow IRA-based plans, such as the following, to offer loans: SEP, SARSEP, and SIMPLE IRA. Other types of retirement plans, such as 401(k), profit-sharing and 403(b) plans, are permitted to offer loans, but if they do offer them, the plan document must say so. Check with your employer to find out if your plan allows loans.
What are the terms of the plan’s loan program? If your plan allows loans, the plan must state:
— who is eligible to borrow;
— the maximum amount you can borrow (no more than $50,000);
–how to apply for the loan (some plans may require your spouse to consent to the loan);
–the number of years to pay back the loan (most loans can only be 5 years, longer if the loan is to purchase your principal residence);
–the loan repayment terms (for example, your monthly loan repayment is deducted from your paycheck); and
–what happens if you default.
What happens if you leave your job before you repay the loan? If you quit, retire or are terminated, your plan administrator may “accelerate” repayment of the loan. This means you would be required to repay the outstanding amount of the loan in full at that time or the amount may be deducted from your account balance.
What happens if you don’t repay the loan? When you don’t repay your loan according to its terms, your employer will report its balance as a taxable distribution to you on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., (instructions). You will have to include the balance in your gross income on your income tax return and, unless you meet an exception, you will also have to pay an additional 10% early distribution tax on it. Your loan’s outstanding amount will be subtracted (offset) from your retirement plan account balance.