401k Layoff Trap

I was surpirsed at the “Borrow from your 401k” suggestion. While it’s true that it’s better than cashing out, so many people are being laid off unexpectedly. When this happens, it must all be paid back or considered a cash-out, which comes at a time when people are least able to repay because they just lost their job. It should at least have been mentioned as a consideration.

–Deborah in San Diego

Deborah makes a very interesting point. She’s referring to an article entitled “Need Cash” that discusses 10 ways to raise cash quickly if you’re in a jam.

How widespread is the problem? It’s hard to find many statistics on 401k loans. But a Harvard report (pdf) cites two statistics that point to trouble. The vast majority of plans allow for borrowing (over 85% in 2005, Investment Company Institute, 2006). And they also report that 18% of 401(k) participants had a 401(k) loan in 2006.

We can’t know for sure, but it’s probably not an unreasonable guess that about one in five or six people who are laid off will have a 401k loan outstanding when they get the pink slip.

And, that’s when Deborah’s problem comes in. As a general rule, if you leave your employer you need to repay the 401k loan in full. You may be given a month or so, but that’s it.

Any amounts that you fail to repay are treated like a withdrawal. That means that you add the amount of the loan to your income and you’ll pay normal income taxes on it. Plus, you’ll be liable for a penalty that equals 10% of the unpaid loan.

What can you do about it? First, if you have a 401k loan and think that you could lose your job, you need to take it seriously. Begin by estimating how much the taxes and penalties would cost you if you didn’t repay part or all of the loan. It’ll be bad. But since your income will be lower than previous years (because of the layoff), your tax rate should drop (that assumes no tax rate hikes).

In any event, you need to have some idea of how much the penalties and taxes are. You’ll want to compare that to the cost of other alternatives.

There are a couple of withdrawal exceptions that might help in a layoff situation:

  • You were age 55 or over and you retired or left your job
  • You paid for medical expenses exceeding 7.5% of your adjusted gross income

What if you don’t fit into one of those categories? Your options are limited, but you still have some choices to make.

Now might be the time to consider selling a car. Your ride needs to be worth more than any loans on it. Any cash you raise could help pay off the 401k loan. If you’re not working, transportation won’t be such a big issue. You can always buy another car when you’re employed again.

Do you have a homeowner’s line of credit or enough equity to refinance your home? That could provide some money to repay the 401k loan. Refinancing will be easier before you lose your job. So you might want to consider this if you expect to be laid off.

Using your credit card to pay off the 401k loan is a high-risk strategy. You’ll probably pay a higher interest rate. And, you’ll also need to keep making payments even if your income has dried up. Plus, you’ll be consuming part of your credit line that you may need later.

The only advantage to shifting the debt to a credit card is that you avoid the tax problems of a 401k withdrawal. But it’s wise to compare the numbers before you make a decision.

The unfortunate fact is that most 401k loans were promoted as an painless way to ‘borrow from yourself’. Turns out that’s not so true if times get tough.

Gary Foreman is the editor of The Dollar Stretcher.com and newsletters. Not only does the site host thousands of articles on various ways to save money, but you’ll also find a vibrant forum where people share their dollar stretching ideas. You can comment on this entry here or follow Gary on Twitter.

Published or Updated: October 28, 2012

Comments

  1. 401k Loans are just another area that aren’t fully explained to people much like early withdrawals. I deal with people every tax season who didn’t understand the total taxes that were going to be due on a withdrawal made from their 401k. The 10% penalty is often a shocker, especially for those that chose to not have any taxes held out.

    A 401k Loan can be a good thing if used correctly and with full understanding of the risk. One change I wish Congress would make is making loans not default when you are let go and allowing withdrawals from your 401k without penalty if you are unemployed. I think both of them would help many people out in the current recession.

  2. dolores galizia says:

    i am over 65 and I borrowed from my 401k if I decide to retire before the loan is paid back can they deduct the money from the balance of my plan or is the loan a separate issue.

    • DR says:

      Dolores, you’ll want to confirm this with your 401(k) plan administrator, but I believe that if you fail to repay the loan, it is simply treated as a distribution. You’ll pay taxes on the amount of the loan just as if you simply withdrew the money. Because your are older than 59 1/2, I don’t believe you’ll pay any penalties, but again, your plan administrator can confirm this.

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