How do IRC loan rules apply to 403(b) and 457(b) plans?

Saving for retirement should always be a top priority to ensure your golden years are well-funded.

But occasionally there may be a need to access your retirement funds for life’s necessities.  If possible, it is best to first seek out other sources of income or acquire a loan from your commercial banking institution. This way you can ensure your nest egg continues to grow and earn interest.

Should a loan from your retirement plan become necessary, you may have questions about how much you can borrow and what the terms of repayment are. Here is a quick primer on the important rules and regulations you should be aware of if you are looking to take a loan from your retirement plan.

Not all retirement plans allow loans

First things first, it is important to determine whether your employer’s retirement plan allows for loans. To find out, access your plan document and check whether the plan has a loan option. Next, you must contact your investment provider to determine whether they offer a loan feature and whether they have a minimum loan amount. If your plan document and investment provider allow you take a loan, then you can take a loan for any reason. There are no qualifying events or eligibility requirements for taking a loan from a 403(b) or 457(b) account (there may be minimum loan amounts or other restrictions that you will find in your plan document or from the investment provider).

You are not taxed on a retirement plan loan unless it is deemed a distribution

A retirement loan is considered a distribution and may be taxed unless the following requirements are met:

1. The balance of the loan must be repaid within 5 years unless it is designated for the purchase of your primary residence.
2. Loan payments must include principal and interest and be paid at least quarterly.
3. The loan must not exceed the lesser of:
   1. $50,000 per participant within all plans under one employer per year (from all providers combined). For example, if a participant has a 403(b) and a 457(b) account with the same employer, the rules are combined across both of those plans. The loan amount is reduced by the participant’s highest account balance in the previous 12 months for plan loans; or
   2. 50% of the participant’s vested balance (or up to $10,000, if greater).
4. A 403(b) or 457(b) loan on your principal residence may extend beyond 5 years. The IRS does reference 15 years as being an acceptable term, but does not strictly prohibit a longer loan term.

You can default on a retirement plan loan by not making payments

Even though you are taking a loan from money that you originally contributed to the retirement plan, there are consequences to defaulting on the loan.

1. Loan payments are typically made on a quarterly schedule. If a quarterly loan payment is not paid by the end of the next quarter the loan will default. Some plans may specify a shorter default period. Check your plan document for plan specifics.
2. A defaulted loan becomes a “deemed distribution” for tax reporting purposes. If the defaulted loan distribution does not coincide with a distributable event, a 10% excise tax may be required. The defaulted loan will remain on the participant’s records until a distributable event has been met, or the participant pays back the loan balance. Some of the most common distributable events include reaching age 59 1/2 or discontinuing your service with the employer.
   1. Repayments of a defaulted loan must be made with after-tax funds. Thankfully these default repayments are not included in yearly contribution limits, however, the defaulted loan on a 403(b) or 457(b) account can prevent a participant from obtaining future loans from their retirement plan and is also included in the $50,000 maximum loan limit per year.
   2. A participant with a defaulted loan will be prevented from taking a new loan unless the employer permits payroll deducted payments on the new loan or unless the plan will permit outside collateral. Most employers will not take on the burden or responsibility of payroll deducted loan payments or outside collateral.

You can refinance retirement plan loans

IRS regulations were established in 2002 for refinancing retirement plan loans. A refinanced loan replaces a current loan and the new loan must be added to the outstanding balance of the original loan (if it offers a term longer than the original loan).

Although the IRS rules can be somewhat daunting, National Benefit Services is here to assist you in navigating the complexities of loan rules for your retirement plan.

Should you have any questions on how to start your loan process, please call 800-274-0503 option 5 to speak with a participant relationship specialist.