How to handle a loan from a retirement plan/401(k)?

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Hi! I’m curious if there is any best practice advice for how to handle or at least how to think about the various entries that should result from a loan from a retirement plan.

Take for example a relatively simple case:
Alice’s 401(k) starts off at 100K.
Alice takes a maximum amount (non COVID) 401(k) loan: $50,000 at 5%.

This spawns several Tiller entries:

  1. Alice’s 401(k) balance immediately drops to 50k (no big deal, balance will update)
  2. Alice gets a check for $50,000… which for argument, we’ll say she deposits into a Tiller-tracked checking account (balance should update)
  3. Alice uses that $50,000 to pay off credit cards (this is pretty straightforward too… account-to-account’s plus interest expense)
  4. Alice has a loan: 60 payments at 5% Or does she? Her retirement account doesn’t track this as a separate account. This isn’t off the books, per se, but the payments are often deducted post-tax out of her paycheck.
  5. Alice’s 401(k) shows inbound transactions from then on… incoming payments from somewhere … Any ideas on how should these be categorized? Investments? Income from the employer? as a direct deposit split of some kind?

Any advice or ideas would be appreciated!
thanks

2

@steven.azar

  1. Does Alice have a loan payable? Sure she does. It is a loan due to the 401k plan.
  2. Why does the loan not show up in any account? It is just like if you loaned your brother $1,000. That loan does not show up in any account that you can link to Tiller. Nevertheless, there is still a loan.
  3. The employer deducts the monthly loan repayment amount from the employee’s paycheck and pays it over to the 401k plan.
  4. Let us assume the monthly repayment amount is $500 ($400 of interest and $100 of principal).
  5. The employee will see a $500 deduction from their paycheck and a $500 incoming payment into their 401k plan account.
  6. The employee will use Tiller’s splitter tool to split this $500 out of their net payroll check ($400 as interest expense and $100 as principal). The $100 principal is coded as a transfer.
  7. The employee’s 401k plan account will show an incoming payment of $500. The employer tracks the loan balance on a schedule. The employer’s schedule will now show the loan balance to be $49,900 (50,000 - 100). Assuming no changes in investment prices during the month, the 401k plan balance will show $50,500 (50,000 + 500).
  8. The employee has $400 of interest expense and the 401k plan has $400 of interest income. Remember, income inside of a 401k plan is not taxable. Yes, the employee is paying the interest to themselves.
  9. The $500 transaction will happen every month. The $400 will decrease over time and the $100 will increase over time.
  10. The employee will create a manual liability in Tiller for the initial $50,000 loan payable and reduce it each month by the portion of the $500 that represents principal.
  11. Let us assume that in a few years from now the loan balance is $25,000.
  12. At this time, let us assume that the employer/employee relationship ends.
  13. What happens to the loan now that the employee no longer has a paycheck from the employer to continue the $500 monthly repayments?
  14. Upon termination, the employer will ask the employee to immediately pay off the loan.
  15. Assume the employee has no funds to pay off the loan.
  16. Assuming the employee does not pay off the loan, the employer will reclassify the loan receivable to a distribution on the books of the 401k plan.
  17. Likewise, the employee will reclassify their loan payable to income on their books. This will result in a manual Tiller entry to reduce the $25,000 loan payable to zero and increase income by $25,000 (call it income from 401k plan distribution).
  18. As a result, the employee has $25,000 of taxable income (both federal and state), probably does not have the money to pay these taxes, and is probably subject to the 10% early withdrawal penalty.
  19. Let us say the employee gets the idea of not reporting the $25,000 on their tax return. Nobody is going to know, right? Wrong. The employer/401k plan will report this $25,000 distribution to the IRS. The employee will receive a Form 1099-R. So will the IRS. Fail to report the $25,000 and you will receive a matching notice from the IRS. The IRS will charge interest on the tax liability shortfall and maybe penalties. And the saga continues.

Cheers,

Blake

1 Like
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Excellent analysis… thank you so much, Blake!