An article appearing in TheStreet.com says that borrowing from retirement plans has been surging. In hard times like the present, these loans are attractive to plan participants. As this article points out, it relatively easy to get this type of loan, as there is no bank or other institutional lender involved. Also, there is usually no risk of denial or need for collateral, and (when the lender/plan is a defined contribution plan-the most usual case) the interest due on the loan is paid to the participant’s own account in the lending plan.
The problem to watch out for is the plan loan, and even more, becoming taxable. To the extent that the loan is taxable for federal income tax purposes, the loan is taxed at ordinary income rates and further, if the participant is under age 59½, a 10% penalty is imposed on the amount taxable.
What rules govern loan taxability for federal tax purposes? In the case of a qualified retirement plan (again, as are most of the retirement plans which make loans), the rules are found in Section 72(p) of the Internal Revenue Code. Under those rules, generally, a loan from a qualified retirement plan is treated as being a taxable distribution. However, as an important exception, a loan will not be taxable:
–to the extent that the loan, when added to the outstanding balance of all other loans from the plan, does not exceed the lesser of: (1) $50,000 (reduced by the excess, if any, of the highest outstanding balance of loans from the plan during the 1-year period ending on the day before the date on which the new loan is made, over the outstanding balance of loans from the plan on that date (the “1-year excess”) or (2) the greater of one-half of the value of the participant’s vested benefit under the plan (e.g., the participant’s vested account balance in a defined contribution plan) or $10,000; and
–if the loan, by its terms, is required to be repaid within 5 years (except for a loan to finance a principal residence), and to be amortized in substantially level amounts, with payments due at least quarterly, over the term of the loan.
The Treasury regulations under Section 72(p) add a few more requirements (See Treas. Reg. Sec. 1.72(p)-1).
Billups v. Commissioner of Internal Revenue, T.C. Summary Opinion 2009-86, illustrates a failure to meet the foregoing exception, so that a new plan loan, and even more, was taxable. In this case, the taxpayer, not yet 59 ½ years old, was employed by the New York City Transit Authority (the “NYCTA”), and was participating in the New York City Employees’ Retirement System (“NYCERS”), a qualified retirement plan. On April 29, 2005, the taxpayer replaced a prior loan from NYCERS with a new 5-year loan, and received cash proceeds of $12,630 from NYCERS as a result. The prior loan had an outstanding balance of $27,012.73. The taxpayer’s receipt of $12,630 increased his outstanding loan balance under NYCERS to $39,642.73, the amount of the new loan. On April 29, 2005, the taxpayer’s vested account balance in NYCERS was $52,863.38, and ½ of that amount was $26,431.69.
Under these facts, to avoid tax on the new loan, the $39,642.73 amount of that loan, when added to the outstanding balance of all other loans from the plan, $27,012.73, could not exceed the lesser of (1) $50,000 (reduced by the 1-year excess-assumed by the Tax Court to be negligible for lack of information provided) or (2) the greater of $26,431.69 or $10,000. Here, however, the $39,642.73 amount plus the $27,012.73 old loan balance equals $66,655.46, which exceeds the $26,431.69 limit, resulting in a taxable amount of $40,223.77 (although the Tax Court made some further adjustments to the actual taxable amount here). Since the taxpayer was under age 59 ½, the Tax Court imposed the 10% penalty on the taxable amount.
Note: Since the new loan had a 5-year term, the statutory maximum, the entire new loan could be outstanding after the term of the replaced loan had ended. Thus, the entire amount of the new loan is taken into account when computing the amount taxable. Taxwise, it might have made more sense for the taxpayer to leave the old loan in place, and borrow only $12,630 (the total proceeds he received upon taking the new loan and cancelling the old one) with a 5-year term, since the taxable amount (without the Tax Court adjustment) would then have been only $13,211.04 (which is the $27, 012.73 old loan balance plus the $12,630 new loan minus the $26, 431.69 limit).