Avoid the Hidden traps of retirement plan loans

When you are looking for a loan, one option you can consider is to take out a loan from your retirement plan. These loans do not require a credit check, and they generally have very favorable interest rates. For employees who are having trouble securing a loan, borrowing from their retirement plan can be an easy way to secure a loan. However, these plans can be dangerous if not treated with proper caution.

There are complex rules that go along with these loans, and defaulting on the loan results in the remaining balance being considered a taxable distribution from the plan and can be subject to the 10% early distribution penalty.

Defaulting on the loan results in the remaining balance being considered a taxable distribution, subject to a 10% penalty

Requirements for retirement plan loans

There are 3 requirements that must be met in order to receive a loan from your retirement plan:

  1. The entire loan balance must be repaid within five years, except in cases where the loan is used to purchase a principal residence.

  2. The loan must be repaid using equal payments on at least a quarterly basis, meaning you cannot make small payments for 4 years and one large payment in the last year.

  3. The loan balance cannot exceed $50,000, or one-half of the account balance, whichever amount is lower.

Repayment of loans

In order to avoid the loan being treated as a distribution, you must make all of the payments on time. Plans will generally offer a grace period on missed payments up to the end of the next quarter after the payment was due. However, some plans offer smaller grace periods or no grace period at all.

What happens when you leave your job while you are still repaying a retirement plan loan? Most companies don’t want to deal with collecting payments from individuals who no longer work for them. When you leave your job you will be given 60 days to pay off the balance of the loan. Any amount not paid off in the 60 days will be deducted from the balance of the plan and will be considered a distribution, which will be taxable and subject to the 10% penalty for early distribution.

Key Takeaway

Taking out a loan from your retirement plan can be an easy way to secure a loan. There are no credit checks or high interest rates. However, the tax penalty can be painful if you are unable to make the required payments.

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