Tax Planning by contributing then borrowing from 401K

[AZ-Tax]

Client was telling me they can borrow from their 401K, be charged a 3% rate credited back to the employee while still contributing to thier 401K. This in a way sounds to good to be true. Employee contributes to 401K thus reducing box 1 on W-2 and then borrowing most of the 401K contribution back out. Will the employee receive some tax document regarding the 401K loan that will need to be reported on the employees tax return?

[Koss]

401(k) loans

This is legit, but it's a little more complicated than it sounds.

The loans are installment loans. Some companies may require that the monthly payments be made through a payroll deduction. And normally you can only have two loans out at any given time. There is no prepayment penalty. But it's not a revolving line of credit. You can't contribute money to the 401(k) and then take it out as a loan the following week.

If you fail to make the payments, then the loan becomes a premature distribution.

If you leave your job, for any reason, the loan becomes due in full, and if you fail to pay it off, then it becomes a distribution.

So it's not without risk.

Also: 3 percent might be an attractive rate at which to borrow your own money, but it's not a competitive rate of return for the funds in the 401(k). Most people feel that their 401(k) should be in stock, earning a rate of 6 to 8 percent or more. So you're giving up some of the gains within the retirement plan.

BMK

[FEDUKE404]

Also...

While many/most 401(k) plans with loan options shout "you're just paying yourself" they barely whisper that the underlying assets to support such loans are no longer earning the account holder anything at all.

So the true overall cost for that loan can be much more than the mere finance charge, especially whenever the stock market decides to recover.

And Koss makes a very valid point about a person who leaves employment with a 401(k) loan still in place. I've had a couple of clients to go pale when they saw the tax effects (federal/state/10% penalty) that came along with that "forgotten" loan....

FE

[JohnH]

Same situation here - I've seen several people suffer through this mess. The most likely scenario is when someone gets downsized and they had a 401k loan in place. At the very worst possible time (no job, financial uncertainty, trying to conserve cash, making do on unemploytment and/or underemployment, etc), they are hit with the tax and penalty on a 401k loan that has fallen due because of a separation from service. Not a pretty picture.

[Burke]

Will the employee receive some tax document regarding the 401K loan that will need to be reported on the employees tax return?

He certainly will if he defaults on the loan or terminates his employment with the loan still outstanding. It is called a 1099-R, and there will be a 10% penalty for early distribution if under 59 1/2. Most of the 401k plans which permit loans that I have seen, limit the amt you can borrow to 50% of the account.