My father used to tell me that banks were in the business of lending other peoples’ money (depositors) to people who don’t need it (rich borrowers). That insight stuck with me for many years.
Whether it is true or not, it is certainly true that it can be very difficult to borrow money under the best of circumstances. Typically banks are seeking people who have a long is history of significant income, adequate collateral, good credit rating, etc. that reflect a near certain ability to repay.
This makes it especially difficult for young people just entering the workforce to borrow money, especially for such uncertain things as starting their own businesses. We as parents are often asked to step in and try to help. This typically includes our cosigning their note, perhaps making a significant cash deposit, providing some kind of adequate collateral, etc. For many of us who are older we may not be able to do this or if we can, it may damage us financially if the kids fail to repay.
So what to do ?
Today we are going to talk about a tax alternative to borrowing from a financial institution. Perhaps we can borrow money from our own interest in a retirement plan. Many employers have retirement plans such as a 401(k), and many of them allow participants to borrow money against our share of the plan. The Internal Revenue Code allows us to do this under certain conditions if certain formalities are followed. Here are some of the more important ones :
- Amount of Loan
The tax code limits the amount that you can borrow from your retirement plan to one half of your vested interest, not exceed $50,000 per participant or beneficiary. There are other more complex limitations not worth discussing here.
- Loan Documents
Your loan must be evidence by a legally enforceable document. This is typically a written agreement that complies with certain tax laws. It must contain the amount that you’re borrowing, the date you borrowed it, and the repayment schedule. Most importantly it must be enforceable under state law.
The only required collateral is your interest in the plan. That’s right, you need not pledge other personal assets.
- Term of Loan
In general, the loan must be repaid in full within five years. However, there is an exception for plan loans that are used to acquire a principal residence. These may be paid off over a much longer period of time, as long as 15 years. This is an important exception as it allows us to pay for our own home through a loan from our own retirement plan.
- Deductible Interest
The interest on a plan loan used to buy a home is typically deductible on our personal returns. It would also be tax free to our share of the retirement plan. Thus we are essentially paying ourselves that interest (often a welcome increase over the 1% banks are paying on our deposits).
- Level Repayments
The tax code requires level amortization payments. This means is that we must make regular payments of the same amount. Most commercial loans are repaid in equal monthly installments. However the tax code allows a retirement plan loan to be repaid as infrequently as quarterly. Making payments every three months might be a real benefit to a startup business when cash flow is irregular. Likewise for individual whose income is irregular (commission salesperson).
The tax code also allows the interest rates to be variable
If the plan loan defaults, then we may not have to repay the money. However, we would have to pay income tax on the unpaid portion of the defaulted loan at the time of default.
Folks, under the right circumstances a loan from your retirement plan may be a reasonable alternative to a bank loan, especially for a home loan or a loan to help your children.
David Leeper is a Board Certified federal tax attorney with 38 years of experience. He can be reached at 915-581-8748, by email at email@example.com, or visit leepertaxlaw.com