Vested Balances: Understanding Loans And Their Impact

A vested balance is the amount of money in a retirement plan that an individual owns outright. This amount includes employee contributions, which are always 100% vested, and any investment earnings. It may also include an employer's contributions, which are subject to a vesting schedule. This means that an employee must remain with the company for a certain number of years before they are entitled to the employer's contributions. If an employee leaves before becoming fully vested, they will forfeit any unvested portion of their balance. In terms of loans, an individual may be able to borrow up to 50% or $50,000 of their vested balance, whichever is less. This loan must be repaid, typically through salary deferral, within five years and the payments must be made at least quarterly.

Borrowing from a 401(k)

The interest paid on the loan is returned to the participant's retirement account, and the cost of a 401(k) loan can be minimal, neutral, or even positive. However, if the loan is not repaid according to the terms, the outstanding balance will be treated as a distribution and will be subject to income tax and a 10% early distribution tax. If the participant leaves their job, their plan may require them to repay the loan in full.

It is important to note that not all 401(k) providers will approve a loan, and the availability of loans depends on the plan. Some alternatives to a 401(k) loan include a hardship withdrawal, which is taxed as ordinary income and subject to a 10% early withdrawal penalty unless an IRS exception applies, or a bank personal loan.

When considering a 401(k) loan, it is essential to weigh the pros and cons and ensure you understand the terms and potential risks.

Vesting schedules

The purpose of a vesting schedule is to incentivize individuals to stay with a company or fulfill specific requirements before fully acquiring the benefits. The vesting commencement date is the starting point for the vesting schedule, from which an individual begins to accumulate ownership rights over time. The vesting period is the duration over which the individual earns ownership, often expressed in terms of years, with a common structure being a four-year vesting period.

There are three main types of vesting schedules: immediate vesting schedules, cliff vesting schedules, and graded vesting schedules. Immediate vesting schedules have no waiting period or specific timeframe for employees to access their benefits. Cliff vesting schedules give employees 100% ownership of the employer's contributions all at once after a certain number of years. Graded vesting schedules give employees ownership of a percentage of the employer's contribution each year. For example, a common graded vesting schedule is to vest 25% after the first year and then an additional 6.25% each quarter thereafter until the fourth year, when 100% ownership is achieved.

It is important for individuals to be aware of the vesting terms when accepting a job or participating in such programs, as it can have a significant impact on their overall compensation.

Retirement plans and loans

Retirement plans may offer loans to participants, but a plan sponsor is not required to do so. Profit-sharing, money purchase, 401(k), 403(b), and 457(b) plans may offer loans. IRAs and IRA-based plans, on the other hand, cannot offer participant loans.

If you are considering taking out a loan from your retirement account, it is recommended that you first consult with a financial planner to determine if this is the best course of action for you. To determine if your plan offers loans, check with the plan sponsor or the Summary Plan Description. If your plan does offer loans, you will need to submit a request for one. The participant should receive information from the plan administrator describing the availability of and terms for obtaining a loan.

The maximum amount a participant may borrow from their plan is typically 50% of their vested account balance or $50,000, whichever is less. An exception to this limit is if 50% of the vested account balance is less than $10,000; in this case, the participant may borrow up to $10,000. It is important to note that the funds you borrow must be repaid to your plan. Additionally, if you do not pay back the loan as per the established terms, it can go into delinquency and eventually default. The outstanding loan balance would then be subject to any applicable taxes and penalties.

In most cases, you will have to pay back the borrowed money, plus interest, within five years of taking out the loan. Your plan's rules will also set a maximum number of loans you may have outstanding from your plan. Some plans may also require the consent of your spouse or domestic partner for you to take out a loan.

Loan repayments

When it comes to loan repayments, there are a few key things to keep in mind. Firstly, the maximum loan amount that can be borrowed from a retirement plan is generally the lesser of two amounts: 50% of the vested account balance, or $50,000. For example, if an individual has a vested account balance of $100,000, they can borrow up to $50,000. If their vested account balance is $80,000, they can borrow up to $40,000. It is important to note that this maximum loan amount may be further limited by the plan itself.

Repayments on these loans must be made at least quarterly, and the full loan must generally be repaid within five years. However, if the loan is used to purchase a primary residence, the law provides an exception to the 5-year requirement. In the case of active members of the armed forces, employers may suspend loan repayments during their period of active duty and extend the loan repayment period accordingly. In other cases, if an employee's salary is reduced during a leave of absence, the employer may suspend repayment for up to a year, but the loan repayment period may not be extended, and the employee may be required to increase their scheduled payment amounts.

If an individual fails to make payments on a plan loan, they may still be able to correct the issue using the Voluntary Correction Program. Additionally, missed payments can still be made even after a deemed distribution has occurred, which will increase the participant's tax basis under the plan. It is important to note that if loan repayments are not made at least quarterly, the remaining balance may be treated as a distribution, subject to income tax, and possibly an early distribution tax of 10%.

If an individual terminates their employment or the plan itself is terminated, the plan sponsor may require them to repay the full outstanding balance of the loan. If the individual is unable to repay the loan, the employer will treat it as a distribution and report it to the IRS on Form 1099-R. To avoid immediate income tax consequences, the individual can roll over the outstanding balance to an IRA or eligible retirement plan by the due date for filing the Federal income tax return for the year in which the loan is treated as a distribution.

Taxes and penalties

When considering a 401(k) loan, it is important to be aware of the potential taxes and penalties that may apply. While loans from a retirement account are generally not taxed, if you do not pay back the loan as per the established terms, it can go into delinquency and eventually default. In such cases, the outstanding loan balance would be subject to applicable taxes and penalties.

The rules regarding loans, withdrawals, and repayment methods vary depending on the workplace plan. It is important to consult the specific plan details to understand the associated taxes and penalties. Some plans may offer flexibility in terms of loan repayment, such as suspending repayments during a period of active duty for employees in the armed forces or during an approved leave of absence.

It is worth noting that the maximum loan amount is typically limited to either 50% of the vested account balance or $50,000, whichever is less. This means that if you have a vested account balance of $100,000, the maximum loan amount you can take is $50,000. However, if your vested account balance is lower, let's say $40,000, the maximum loan amount would be $20,000.

Additionally, it is important to understand the concept of "deemed distributions." Loans that exceed the maximum amount or do not follow the required repayment schedule are considered deemed distributions. In such cases, the remaining balance is treated as a distribution that is subject to income tax and may also be subject to an early distribution tax of 10%.

To avoid immediate income tax consequences, individuals can roll over the outstanding loan balance to an IRA or eligible retirement plan by the due date for filing the Federal income tax return for the year in which the loan is treated as a distribution. This option allows for tax deferral on the rolled-over amount.

Frequently asked questions