IRS clarifies maximum 401(k) loan amount rules: What Finance must know

Employers now have a bit more clarity when it comes to determining how to calculate the maximum amount of a participant’s 401(k) loan if they have taken out prior loans during the same plan year.
IRS recently issued a Memorandum for Employee Plans (EP) Examinations Employees.
This memorandum offered two methods for calculating a maximum 401(k) loan for staffers’ with prior loans.

The lesser of …

According to the feds, the max loan amount is the lesser of:

• 50% of the participant’s vested account balance, or
• $50,000 less the highest outstanding balance within one year of the loan request.

Before the Memorandum, the law wasn’t clear on how to calculate a max loan when another loan was taken out during the plan year.

3 ways to discourage a loan

Of course, employers should be doing everything possible to discourage 401(k) loans in the first place.

Here are three reasons why employees should only dip into their retirement savings as a last resort.

1. It’s very hard to make up the lost savings

Many people are able to repay their 401(k) loans without incurring penalties. Even so, the lost opportunity for account growth is very tough to make up in other ways.  An employee who earns $40,000 a year and takes just a modest $2,500 loan will cost himself nearly $15,000 —  even if the loan is repaid in full without penalties.

Another problem: Employees who take out 401(k) loans get taxed twice. Tthe loan itself isn’t taxed, but the repayments come from regular taxed payroll dollars. And unless the employee has a Roth 401(k), the account will be taxed when it’s cashed out upon retirement. But either way, employees end up paying Uncle Sam twice for the same money.

2.  Built-in disincentives

While the interest rate on a 401(k) loan may be reasonable, there are often other sorts of fees that jack up the cost of borrowing against the account. Some plans charge fees for processing the loan.

In addition, some employers’ plans disqualify the employee from further 401(k) participation until the loan is paid off in full. This further depletes the employee’s final account balance — often by huge sums of money.

Alternatively, some employees reduce their contributions in order to afford to repay the loan. While this works in the short-term, over the long haul it depletes the value of the 401(k) account.

3.  Repayment schedule can change

The repayment schedule on a 401(k) is set as long as the employee remains at the company and eligible to participate in the plan. But if employee loses his or her eligibility to participate in the plan (e.g., a permanent switch from full-time to part-time status, voluntary or involuntary termination), the repayment schedule is out the window.  Typically the full repayment is due within 60 days.

What happens if the employee can’t repay? The IRS treats the remaining  balance like a cash-out. Now the employee gets clobbered with a 10% penalty and owes income tax on the money.