In Employee Plans News (December 17, 2010), the Internal Revenue Service (the “IRS”) provides guidance on the tax consequences of a second plan loan.
The IRS posits the following example: The plan participant, P, asks for a second plan loan. P’s vested account balance is $80,000. Eight months ago he borrowed $27,000, and still owes $18,000 on that loan. A few points. First, P could take a second loan only if the plan’s terms allow it. Second, the maximum amount that P may now borrow, without being taxed, is determined under Section 72(p)(2)(A) of the Internal Revenue Code. Using the example, under that Section, P will be taxed unless the new loan, plus the outstanding balance of all other plan loans, does not exceed the lesser of :
(1) $50,000, reduced by the excess of (a) the highest outstanding balance of P’s loans during the 12-month period ending on the day before the new loan (here, $27,000) over (b) the outstanding balance of P’s plan loans on the date of the new loan (here, $18,000); or
(2) The greater of $10,000 or 1/2 of P’s vested account balance.
Here, prong (1) equals $50,000 minus ($27,000 over $18,000), or $41,000, while prong (2) is 1/2 of $80,000, or $40,000. Since the total permissible loan balance is $40,000 (the smaller of prong (1) and (2)), and since P’s has a current outstanding loan balance of $18,000, P can borrow up to an additional $22,000 ($40,000 minus $18,0000) without being taxed.
One more point. If P repaid the $18,000 loan balance before taking the new loan, then prong (1) would be $50,000 minus ($27,000 over 0), or $23,000, while prong (2) would be as above. Thus, P could borrow up to an additional $23,000 without being taxed. There was not much to be gained by paying off the prior loan.