New IRS Guidelines on Max 401(k) Loans

Borrowing From Your Nest Egg: New Clarification and Flexibility

Under the law, an employee can borrow from their 401 (k) plan and repay the loan through future payroll contributions without paying taxes or penalties. Additionally, the interest paid on the loan is added to their retirement investments. The law limits the amount you can borrow to the lesser of 50% of your 401 (k) balance or $50,000.

Adding some complexity, you can take a loan from your 401 (k), pay it off, and again borrow from your 401 (k). If you make multiple loans, however, the aggregate cannot be more than $50,000 within a 12-month period. Although this seems simple, confusion has resulted based on how the 'aggregate' of multiple loans is calculated.

Two Calculation Methods

Let's say Joe owns a growing, profitable side business and needs to borrow from his 401 (k) to purchase materials to fulfill large orders. Setting aside the wisdom of his decision, how often can he do this before hitting the aggregate maximum?

Assume he borrows $30,000 from his 401 (k) in February, and repays the loan by May. In June, Joe borrows $20,000 from his 401 (k) for a second big order and repays the loan by August. If Joe gets another big order in October, can he borrow from his 401 (k) again?

Calculation Method 1

Under one method of calculation, Joe has reached his max. The $30,000 loan plus the $20,000 loan equals the aggregate maximum of $50,000. Based on this calculation, the IRS could say any additional loans are not allowed. To get the money, Joe would have to make an unqualified distribution, paying the taxes and the 10% penalty.

Calculation Method 2

A second calculation method says Joe has never gone above $30,000 in loan debt since the first loan was completely paid off before he borrowed the second loan. His aggregate loan balance is $30,000 thus far. As a result, the aggregate limit minus his previous loan amount ($50,000 - $30,000) means he can again borrow $20,000 to fund his business.

The IRS Offers Clarification

In an April 20th IRS Memorandum, the IRS clarified how agents should treat the question of if the aggregate amount is reached. Keep in mind, these memorandum are guidance for IRS agents and not proclamations of law.

The guidance basically tells agents to look at how the 401 (k) plan administrators want to  calculate the aggregate. If the plan currently calculates the "highest outstanding balance" in either of the two ways above, the law has been met and no further investigation is required.

Consistency and Non-Discriminatory

Although the Memo doesn't address this directly, the IRS generally views consistency and fairness as requirements for taxpayers and plan administrators. As a result, the 401 (k) plan should be using one of the two methods of calculation consistently. The plan should also not use one calculation for higher-paid employees and another for lower-paid employees, which the IRS would view as discriminatory.

What It Means For You

If you are in the situation of wanting to borrow multiple loans from your 401 (k) plan,  the holder of the answer is your plan administrator. This usually means your Human Resources Department (HR) or the investment company that handles your company retirement plan.

Begin by contacting HR or the investment company to answer how your company calculates the aggregate loan balance. If the plan has never encountered this issue before, providing them with a copy of the IRS memo (linked above) can help your plan administrator make a more confident decision.

The Wisdom of Borrowing From Your 401 (k)

If you are dutifully saving for your retirement, borrowing from a retirement plan is a double-edged sword. On the one hand, you are paying yourself interest instead of a bank. Additionally, the assets never technically leave your retirement account as you are now invested in a note you made to yourself, just like a bond is a 'note' a company makes to you.

On the other hand, the interest you pay yourself is unlikely to match up to the growth you could earn over long periods from investing in stocks or other investments. Additionally, if you lose your job, you have to repay the entire amount immediately or the IRS will treat it as a distribution subject to taxes and the 10%  penalty.

Borrowing from a 401 (k) should be done only in circumstances where the benefit outweighs the risks. This limits the number of reasons to a small subset of good debt such as purchasing a new home, getting an advanced degree, or growing an existing successful business. Before borrowing from your 401 (k) you should consult your financial adviser or a tax professional to determine the potential risks and benefit for your specific situation.

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Joshua Escalante Troesh.jpg

Joshua Escalante Troesh is a tenured professor of Business at El Camino College and the founder of Purposeful Finance. His career provides him with a unique insight on personal financial, having been a VP at a financial institution leading up to 2008, and involved with technology and internet stock research leading up to 2000. He can be reached for comment at