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TAKING A LITTLE BIT OF THE STING AWAY

By Ian Berger, JD
IRA Analyst

‘Tis the season for bee stings and mosquito bites.

Just like those summer irritations, 401(k) plan loans have their own annoying rules that can make them risky transactions. Fortunately, a provision of the 2017 tax reform law applied a little hydrocortisone to help relieve the itch.

One advantage that 401(k) plans have over IRA’s is that 401(k)’s (as well as many other employer-sponsored plans) can allow participants to borrow against their accounts. 401(k) plans are not required to allow loans, but most do.

There are benefits and risks to taking a 401(k) plan loan. One major risk is that you could face a big tax hit if you terminate employment with an outstanding loan — whether you leave voluntarily or not.

Some plans allow a grace period to repay the loan before receiving a payout from your account.  But if you are unable to come up with the cash by the end of the grace period, the plan will offset (reduce) your 401(k) account balance by the loan balance. Other plans don’t allow a grace period and will automatically apply the offset.

Here’s where the “owie” comes. The unpaid balance, even though it’s been offset, is still considered taxable income to you. And it gets worse:  you may also owe a 10% early distribution penalty on the unpaid balance (if under age 55).

You could avoid the tax hit by rolling an amount equal to the unpaid balance to an IRA or another employer plan. Before 2018, however, you had only 60 days to come up with the cash for the rollover — often not enough time.

The 2017 tax bill extends the deadline to allow significantly more time to find other sources to roll over the unpaid loan balance. The new deadline is April 15 of the year following the year the offset occurs (or October 15 of the following year if you file for an extension of your tax return).

Example:  Elena, age 45, terminates employment on February 15, 2019 with a $50,000 401(k) account balance, including a $20,000 loan balance. Elena does not have $20,000 to repay the loan balance. She elects to do a direct rollover to an IRA of the difference. On March 10, 2019, the plan offsets her $50,000 account balance by the $20,000 loan balance and transfers $30,000 to the IRA. Under the old rule, Elena would have only 60 days (until May 9, 2019) to come up with the $20,000 to roll over. Otherwise, she would owe taxes on the $20,000 and be hit with a 10% early withdrawal penalty of $2,000. Under the new rule, however, Elena has until April 15, 2020 (or October 15, 2020 if she files for an extension of her 2019 tax return) to find other sources for the $20,000 so she can complete a rollover and avoid the tax “sting.”

https://www.irahelp.com/slottreport/taking-little-bit-sting-away

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Investment advisory services offered through Foundation Investment Advisors, LLC, a SEC-Investment Advisor Representative. Foundation Investment Advisors, LLC does not provide legal or tax advice. Investment Advisor Representatives of Foundation Investment Advisors, LLC may only conduct business with residents of the states and jurisdictions in which they are properly registered or exempt from registration requirements. Insurance and annuity products are sold separately through Chadmere Captial. Securities transactions for Foundation Investment Advisors, LLC clients are placed through TD Ameritrade.