If you find yourself in need of cash but don't want to pay interest to a bank, you may be able to borrow from a lender you haven't considered: yourself. If you have a pension or profit-sharing plan through your employer, such as a 401(k) or 403(b) plan, you may be able to borrow money from your account.
The IRS permits employer plans to allow loans but does not mandate that all plans offer them. That leaves it to your employer's discretion as to whether to allow the plan to offer loans. Contact your company's human resources department or check the plan documents to determine whether your plan offers loans. If your employer doesn't allow loans, you're out of luck.
The IRS restricts your loan to the smaller of $50,000 or half your vested account balance. You cannot borrow from any amounts not yet vested. For example, if your employer requires you to work for three years before you are vested in any of the employer contributions and you have only worked two years, you cannot count employer contributions in your account when figuring the maximum loan. However, if you have a smaller account balance, you can borrow the smaller of your vested account balance or $10,000.
You must generally repay the money borrowed from your pension within five years using substantially level, or equal, payments. These payments must be made at least quarterly, but many employers allow you to make the repayments through payroll deductions. In addition, you have to pay a reasonable interest rate on the loan, but all of your repayments, including the interest, go back into your account. The downside to the loan is that you miss out on whatever investment income you would have earned if the money had remained in the pension.
Consequences of Not Repaying Loans
If you fail to repay a loan from your profit-sharing plan, the IRS treats you as if you took a distribution from the plan equal to the amount outstanding at the time you defaulted on the loan. For example, if you had a balance of $10,000 remaining to be paid when you defaulted on the loan, the IRS treats it as a deemed distribution, meaning it becomes taxable to you. If you are under 59 1/2, you'll also owe an extra 10 percent additional tax because it is not a qualified distribution.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."