Many plan participants are looking to retirerment plans for temporary relief of their financial distress.  There are, unfortunately, tax consequences of employee plan loans and hardship distributions.

Only qualifed plans, such as profit sharing, 401(k) and money purchase plans may allow participants to borrow money from their accounts, and only if the plan documents specifically permits such loans to be made.  IRA-based plans, such as SEPs, SIMPLE IRAs and SARSEPs and traditional and Roth IRAs cannot provide loans to participants.

The amount participants may borrow is limited to the lesser of:  $50,000 or 50% of the vested account balance (the amount that actually belongs to the participant, even if employment is terminated).  Loans must be paid back at least quarterly, over a period not exceeding five years.  There is an exception to the 5-year rule for loans taken out for the purchase of a participant's principal residence.

Loans that initially don't meet Code requirements (if they are not limited to 50% of the vested account balance, or if they exceed $50,000) are treated as a distribution when the loan is made and are taxed accordingly.  If a payment is mssed, it causes the loan to go into default and therefore be taxed as a distribution.

When a participant terminates employment with an outstanding plan loan balance, plans usually offset the termination distribution to the participant by the amount of the oustanding loan balance.  The participant will be taxed on the full amount of the distribution, including the loan balance. If the participant wants to roll over the entire benefit, he/she must come up with the money that represents the loan offset as well as the mandatory 20% federal withholding tax that applies to the full amount, including the loan offset. 

The additional 10% early distribution tax will apply if the participant is under age 59 1/2 unless an exception to the early withrawal tax applies, if the full amount of the retirement plan distribution is not available for rollover because the participant does not have funds to repay the loan and tax to make the distribution the whole amount.

An owner-employee may borrow from the company's plan but must follow the same rules that apply to other participants.  If all the plan requirements are not met, it may be tagged a prohibited transaction.

Some retirement plans may allow participants to withdraw certain amounts from the plan because of a financial hardship.  In general, a plan may make a hardship distribution only:  if the plan permits such distributions; bacause of an immediate and heavy financial need of the employee (and in certain cases, the employee's spouse, dependent or beneficiary); and in the amount necessary to meet the financial need.

Hardship distributions are not tax free money.  Generally, they are subject to income tax in the year of distribution, and if the employee is under 59 1/2, the 10% early distribution tax applies unless some exception to this tax applies.  Hardship distributions are not, however, subject to the 20% mandatory withholding.