There are three scenarios in which a participant does

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There are three scenarios in which a participant does not want to take a loan. The first scenario is when the other investments within their 401(k) would earn them considerably more than the loan interest rate (opportunity cost of capital). The second and third scenarios will be explored in more detail later in this lesson. These scenarios occur if the participant is too close to retirement or if they would possibly not be able to repay the loan and therefore default on themselves. Plan Loan Rules ERISA has a few rules in place to govern the use of plan loans. Their first rule is that they must be reasonably available to all participants within a plan if they are offered at all. It would be discriminatory if plan loans were only available to executives or business owners and not available to the rank-and-file. Their second rule is that the loans must be “adequately secured.” This is generally interpreted to mean
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that any plan loans should not exceed 50% of the vested balance in the account. Plan loans are essentially secured by the assets that remain in the retirement account. Their third rule is that plan loans must charge a “reasonable” rate of interest. This is generally thought to mean that the plan should use a current market loan rate. They cannot offer loans at 1.5% interest if loans everywhere else are charging 5.5%. This would create (1) an unfair advantage for plan participants and (2) demand for loans that may not be needed . The IRS has its own set of rules governing plan loans. In order to avoid the “loan” being deemed a “withdrawal”, the loan cannot exceed the lesser of $50,000 or 50% of the vested account balance. This last sentence is very important to understand! This loan limit is reduced if there are other outstanding loans from the plan. The IRS also mandates that all plan loans must be paid back within 5 years (5-year level amortization). The one exception to the 5-year payback rule is for a loan to purchase a house. The payback period is then 30 years, but this presents some other challenges. Do you really think that the available return on plan assets over a 30-year time period will be less than the current market interest rate? Taking a 30-year mortgage loan from your retirement account is unwise. Another reason that 30-year plan loans are unwise is because of the increased risk of default over that long of a time period . If an employee retires and they still have an outstanding loan balance, then they are deemed to have defaulted on the loan. What if an employee actually defaults on a plan loan by missing a series of payments? In a default scenario, whether actual or deemed, the remaining plan loan balance is considered a withdrawal by the IRS. Withdrawals from retirement accounts are 100% taxable as ordinary income (with the exception of pro-rata cost basis recovery from VAT contributions). Can you imagine defaulting for whatever reason on a $50,000 plan loan? If the participant could not make monthly payments, where will they come up with the money for taxes? To compound the potential
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  • Spring '14
  • VOSS,JAMESA
  • Cash balance plan, HCES

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