What Happens If You Leave Your Job
When you take out a loan from a 401, you may have no intention of leaving your current employer. But if you receive a better job offer, or are laid off or otherwise leave, you could be required to pay the loan back in full or face some serious tax consequences.
Employees who leave their jobs with an outstanding 401 loan have until the tax-return-filing due date for that tax year, including any extensions, to repay the outstanding balance of the loan, or to roll it over into another eligible retirement account. That means if you left your job in January 2020, you would have until April 15, 2021 when your 2020 federal tax return is due to roll over or repay the loan amount. Prior to the Tax Cuts and Jobs Act of 2017, the deadline was 60 days.
If you cant repay the loan, your employer will treat the remaining unpaid balance as a distribution and issue Form 1099-R to the IRS. That amount is typically considered taxable income and may be subject to a 10% penalty on the amount of the distribution for early withdrawal if youre younger than 59½ or dont otherwise qualify for an exemption.
Unfortunately, this worst-case scenario isnt rare. A 2014 study from the Pension Research Council at the Wharton School of the University of Pennsylvania found that 86% of workers in the sample who left their jobs with a loan outstanding eventually defaulted on the loan.
Loans To An Employee That Leaves The Company
Plan sponsors may require an employee to repay the full outstanding balance of a loan if he or she terminates employment or if the plan is terminated. If the employee is unable to repay the loan, then the employer will treat it as a distribution and report it to the IRS on Form 1099-R. The employee can avoid the immediate income tax consequences by rolling over all or part of the loans outstanding balance to an IRA or eligible retirement plan by the due date for filing the Federal income tax return for the year in which the loan is treated as a distribution. This rollover is reported on Form 5498.
Retirement Plans Faqs Regarding Loans
Information on this page may be affected by coronavirus relief for retirement plans and IRAs.
These frequently asked questions and answers provide general information and should not be cited as any type of legal authority. They provide the user with information responsive to general inquiries. Because these answers do not apply to every situation, yours may require additional research.
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How Much Can You Borrow
Plans can set their own limits for how much participants can borrow, but the IRS establishes a maximum allowable amount. If your plan permits loans, you can typically borrow $10,000 or 50% of your vested account balance, whichever is greater, but not more than $50,000.
But the CARES Act provides some exceptions to that limit. The law allows those who qualify to borrow up to $100,000 loans from your plan) or 100% of your vested account balance, whichever is less. That provision expires on Sept. 22, 2020.
To qualify, you likely need to fall within at least one of several scenarios, including
- You, your spouse or a dependent is diagnosed with COVID-19
- You experience financial hardship as a result of being quarantined, furloughed or laid off, or your hours are reduced because of COVID-19
- You cant work and are experiencing financial hardship because the COVID-19 crisis has cut off your access to childcare
- You have financial troubles because a business you operate or work for closes or reduces its hours as a result of COVID-19
Why Take A 401 Loan
When you need cash and are having trouble getting approved for a loan, taking out a 401 loan may seem like a good idea. These loans have fairly generous repayment terms and are not contingent upon credit approval. You can apply for up to $50,000 without worrying if a bank is going to stick you with a high interest rate or decline your application.
Although a 401 loan is not ideal compared to some alternatives, it is better than others. These are some common reasons when a 401 loan makes sense:
- Need the money for the short term. If you can repay the loan in less than a year, it makes sense to avoid loan fees or higher interest rates of some loan options.
- Avoiding a payday loan. When a payday loan is your only other alternative, a 401 loan helps you avoid predatory fees and interest rates charged by payday lenders.
- Your credit score is bad. Some people have such a high debt that their credit scores are trashed. Taking out a 401 loan allows you to pay down your debt and reduce your credit utilization and improve your credit score. Once your score is higher, you might be able to qualify for better rates and terms from a traditional lender to repay your 401 loan.
- Down payment for a home. Normal 401 loans must be repaid within five years. But, when you borrow from your 401 to buy a home, you can stretch the payments out for up to 25 years.
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Will A 401 Loan Affect My Credit
Taking out a 401 loan has no direct impact on your credit scores.
- You don’t need a credit check to qualify for a 401 loan, so taking one out doesn’t trigger a hard inquiry and result in a temporary dip in credit scores.
- Payments on 401 loans are not tracked by the national credit bureaus , so they do not appear in your credit reports and cannot factor into credit score calculations. If you miss a payment or even default on the loan, your credit scores will not change.
Note, however, that the extra tax and penalty expenses that come with a 401 loan default can make it difficult to pay your credit bills, which can jeopardize your credit standing indirectly.
What Happens When A Participant Is Late On A Payment Misses A Payment Or Employment Is Terminated
- Late or missed loan payments should be paid in a timely manner to avoid default, taxation and penalties.
- Defaulted loans are subject to an additional 10% excise tax if the participant is under age 59½.
- Upon termination, the outstanding loan balance becomes due.
- If not repaid promptly, the loan will be considered in default and may be deemed a taxable distribution to the participant.
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When Should I Take Out A 401 Loan
Most employer-sponsored 401 retirement plans allow employees to borrow against their accounts, but employers can restrict what you’re allowed to use the funds for. You’re also putting your retirement savings at risk, so be careful about what you’re borrowing for regardless of if there’s a restriction.
Situations that may necessitate a 401 loan include:
- Funeral expenses
- Making a down payment on a house
- Covering costs to prevent foreclosure or eviction
- Paying education costs for yourself or your family members
Questions To Ask If You’re Considering A 401 Loan
If youre thinking of borrowing from your 401, plan ahead by asking your 401 service provider about the borrowing process, such as:
- Are loans allowed? Ask about the types, terms, and costs.
- How much can I borrow? This varies with your plan balance.
- What are the steps? Processes differ, and there may be paperwork if you want a home loan.
Keep in mind that loan checks are usually mailed, so they may take time to reach you.
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Can 401k Loans Be Paid Off Early
Can 401 loans be paid earlier than the five-year amortizing payment schedule? Find out what the IRS says, and the options you have.
A 401 loan can be a convenient tool if you are looking for a quick source of cash to pay for emergencies. You can borrow from your retirement savings to pay for college, roof replacement, or to purchase your primary residence. Most employers allow employees to borrow from their 401 retirement savings up to 50% of their vested balance up to $50,000.
A 401 participant can decide to pay off a 401 loan early by making extra payments towards the loan repayment. If the plan requires loan payments to be made through payroll deduction, you can adjust the withholding on the applicable paychecks to increase the loan repayments. 401s do not charge early repayment penalties to participants who pay off the loan early. The loan statement will show the additional credits to the loan account, and the remaining 401 loan principal balance.
What Can Be Done To Remedy A Default After There Has Been A Deemed Distribution
If a participant failed to make payments on a plan loan, the missed payments can still be made even after a deemed distribution has occurred. In that case, the participants or beneficiarys tax basis under the plan is increased by the amount of the late repayments. -1, Q& A-21)
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Make Sure Your Old 401s Are Still Working For You In The Meantime
Rollover your old 401s into your current account. You can monitor its investment performance and reallocate your funds to match your risk tolerance. This will help you better manage your retirement savings to ensure your meeting your retirement goals.
Think About What Would Happen If You Lost Your Job
This is really important. If you lose your job, or change jobs, you cant take your 401 loan with you. In most cases you have to pay back the loan at termination or within sixty days of leaving your job. This is a big consideration. If you need the loan in the first place, how will you have the money to pay it back on short notice? And if you fail to pay back the loan within the specified time period, the outstanding balance will likely be considered a distribution, again subject to income taxes and penalties, as I discussed above. So while you may feel secure in your job right now, youd be wise to at least factor this possibility into your decision to borrow.
Smart Move: To lessen the odds of having to take a 401 loan, try to keep cash available to cover three to six months of essential living expenses in case of an emergency.
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Loans To Purchase A Home
Regulations require 401 plan loans to be repaid on an amortizing basis over not more than five years unless the loan is used to purchase a primary residence. Longer payback periods are allowed for these particular loans. The IRS doesn’t specify how long, though, so it’s something to work out with your plan administrator. And ask whether you get an extra year because of the CARES bill.
Also, remember that CARES extended the amount participants can borrow from their plans to $100,000. Previously, the maximum amount that participants may borrow from their plan is 50% of the vested account balance or $50,000, whichever is less. If the vested account balance is less than $10,000, you can still borrow up to $10,000.
Borrowing from a 401 to completely finance a residential purchase may not be as attractive as taking out a mortgage loan. Plan loans do not offer tax deductions for interest payments, as do most types of mortgages. And, while withdrawing and repaying within five years is fine in the usual scheme of 401 things, the impact on your retirement progress for a loan that has to be paid back over many years can be significant.
If you do need a sizable sum to purchase a house and want to use 401 funds, you might consider a hardship withdrawal instead of, or in addition to, the loan. But you will owe income tax on the withdrawal and, if the amount is more than $10,000, a 10% penalty as well.
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Why You Shouldnt Take A 401 Loan
Its awfully tempting. You see that money in your 401 plan account just sitting there. And you think of all the possible uses for it. Why not take a loan? You will pay it back with interest!
Generally, that is a really bad idea. Here are the reasons why.
You will likely forfeit some company matching contributions
Many individuals who borrow from their 401 accounts end up stopping or lowering their contributions while they are paying back their loans. This often results in the loss of 401 matching contributions when their contribution rates fall below the maximum matched percentage.
There is no better investment you can make than receiving free money in the form of company matching contributions. It is the safest, easiest way to earn 25%, 50% or 100% depending upon your companys matching percentage.
Job changes can force defaults
Most individuals considering a job change dont realize that their outstanding 401 loan balance becomes due when they leave their employer. In the case of an involuntary job loss, an outstanding 401 loan can add significant pain to an already difficult situation.
Regardless of whether a job change is voluntary or involuntary, few of us have the financial resources available to immediately pay back a 401 loan if we leave our employer. As a result, most of us are forced to default. Note, the new tax law gives a little leeway on the time to repay until your tax return due date the next year.
The opportunity costs can be substantial
Why Do People Get 401 Loans
As long as a plan allows it, participants generally can borrow from their 401 for any reason. Some plans may only allow loans for specific reasons, so be sure to check your plans rules before trying to borrow.
Since youre borrowing your own money, and no credit check is involved, it may be easier to get approved for a 401 loan as long as you meet the plans requirements for borrowing. In some cases, a requirement may be getting approval from your spouse , because your spouse may be entitled to half of your retirement assets if you divorce.
Here are some potential uses for a 401 loan.
- Paying household bills and expenses
- Funding a down payment on a house
- Paying off high-interest debt
- Paying back taxes, or money owed to the IRS
- Funding necessary home repairs
- Paying education expenses
But that doesnt mean 401 loans are always a good idea. In fact, there are some major risks that come with borrowing from your retirement savings. Here are two.
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Is A Deemed Distribution Treated Like An Actual Distribution For All Purposes
No, a deemed distribution is treated as an actual distribution for purposes of determining the tax on the distribution, including any early distribution tax. A deemed distribution is not treated as an actual distribution for purposes of determining whether a plan satisfies the restrictions on in-service distributions applicable to certain plans. In addition, a deemed distribution is not eligible to be rolled over into an eligible retirement plan. -1, Q& A-11 and -12)
If Youve Got A Pressing Financial Concern And Money In Your 401 You May Be Tempted To Take The Cash Out By Taking A 401 Loan After All The Money Is Just Sitting There Youd Be Paying Interest To Yourself If You Took Out The Cash And You May Have Plenty Of Time To Put The Money Back Before Retirement
While it can theoretically seem like a smart financial move to use that money to pay off high-interest debt, put down a down payment on a house, or fulfill another immediate need, you should resist the urge and leave your 401 cash right where it is. The money already has a job helping you afford food, housing, and medicine when youre too old to work and the only reason you should ever take it out is for a true life-and-death emergency.
Here are four big reasons why you should leave the money in your 401 alone so you dont have major regrets later.
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Loans That Do Not Meet Legal Requirements
Loans that exceed the maximum amount or don’t not follow the required repayment schedule are considered “deemed distributions. If the loan repayments are not made at least quarterly, the remaining balance is treated as a distribution that is subject to income tax and may be subject to the 10% early distribution tax. If the employee continues to participate in the plan after the deemed distribution occurs, he or she is still required to make loan repayments. These amounts are treated as basis and will not be taxable when later distributed by the plan.