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Plan Well, Retire Well

Saving and investing your money
401k loan

Transitions: What Happens to a 401(k) Loan When You Leave Your Job?


Did you borrow money from your 401(k) that you haven't paid back yet? You're not alone. According to a study by Aon Hewitt, one in every four participants in these plans has a loan.

What happens to that loan when you leave your job? Whether you retire, are laid off, or move to another company, the options are pretty much the same. And the same rules (question 2) apply to loans for 403(b) plans or retirement plans for government employees.

Most employers will give you 60 days to repay the loan balance. If you don't, the amount will reported to the IRS as a taxable distribution.

What options do you have?

Don't pay the loan.

If you can't repay the loan, the unpaid amount will be reported to the IRS as a taxable distribution, probably labeled as a "distribution of a plan loan offset amount."

Depending on the size of the loan, that could result in an unpleasant tax bill next April, and possibly penalties for underpayment of taxes if you don't calculate and pay quarterly estimated taxes. You could also face a 10% early withdrawal penalty if you are under age 59 1/2. Separating from service when you're 55 or older is usually an exception to the 10% penalty, but it seems to be a grey area where unpaid 401(k) loans resulting in taxable distributions are concerned.

In other words, not paying off the loan could have unpleasant tax consequences.

Another result of not paying off the loan is having less money for retirement. The balance in your retirement account will be permanently reduced, and you'll miss out on the tax deferral you would have gotten on the loan amount plus the earnings on that amount.

Pay the loan within the time allowed by your (former) employer.

If you can pay the loan off within the time allowed by your employer, everything is good. You'll owe no additional taxes, and you'll have more money for retirement, when that day comes.

Check to see if your employer is one of the rare ones that will allow you to continue to make payments after you leave.

As an employee, you repay a loan from your 401(k) through payroll deductions. Once you are no longer an employee, the employer doesn't have any easy way to collect and process your payments. And let's face it: if you no longer work there, they may not want to be bothered with the cost and effort.

A document called the Summary Plan Description should lay out the plan's rules, including loan repayment. You should have been given that document shortly after you were hired. According to the Department of Labor, you should also be able to request it from your employer or the plan administrator at no charge. The plan administrator is the company who runs or manages the 401(k) for the employer. It could be a mutual fund company or some other financial services company.

If your employer allows you to make payments, be certain you make every payment on time. If you miss a payment, the loan will be in default and the balance will labeled as a "deemed distribution." That will be reported as a taxable distribution, and you'll be stuck with the taxes and penalties, period.

Use a roll-over to an IRA to repay the loan

There's an alternate way of paying off the loan that could buy you a little more time.

Here's the official IRS description of how this works:

If you have an outstanding loan from the Plan, your Plan benefit may be offset by the amount of the loan, typically when your employment ends. The loan offset amount is treated as a distribution to you at the time of the offset and will be taxed (including the 10% additional income tax on early distributions, unless an exception applies) unless you do a 60-day rollover in the amount of the loan offset to an IRA or employer plan

In other words, there's a back-door way to repay the loan. From the date when your employer determines that you received a "distribution" of the unpaid loan amount, you have 60 days to make a deposit to either an IRA or a new employer plan equal to the "distribution," and the distribution becomes an indirect rollover. You'll owe no taxes, no penalties, and your retirement savings are intact.

What's the risk?

  • Any amount you don't rollover within 60 days is not a rollover and becomes a taxable distribution.
  • If your employer labels the distribution as a "deemed distribution" instead of an "offset distribution," it's not eligible for rollover  That would occur if you defaulted on your payments while still an employee, or if your employer agreed for you to make payments after leaving employment but you failed to make the payments, and perhaps in other situations. (For an explanation of deemed distributions, see https://www.law.cornell.edu/cfr/text/26/1.72(p)-1, question 13).
  • As of 2015, you are limited to one indirect rollover per twelve months, for all of your IRA accounts. If you already made an indirect rollover during the past 12 months, you are not eligible to make another indirect rollover.

You may want to get some expert tax guidance before initiating this process, to be sure you get it right. Or if you're up for reading some pretty dense details, check out these sections of the tax code provided by the Legal Information Institute at the Cornell University Law School:

 

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This post is part of a series about the decisions faced during a job transition, whether you're being laid off, retiring, or moving to another job. The initial post lists some of the topics I'm addressing, as well as why I'm writing about this issue. You can find other posts in this series by clicking the category Job Loss on the right side of this screen. To receive notices about future posts, you can subscribe to our monthly e-newsletter, which provides links to all of our new blog posts.

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