401(k) loans have become so common that most people who have them pay very little attention to them. That’s easy to do, given that repayments are deducted from your payroll, and largely invisible.
But if you’re changing jobs, or if you leave your employer for any reason, an outstanding 401(k) loan balance can present a problem. Should you borrow to repay a 401(k) loan?
That’s what we’re going to discuss in this article, as well as other possible workarounds.
How 401(k) Loans Work
We’re talking specifically about 401(k) loans, but the same rules also apply to profit-sharing, money purchase, 403(b) and 457(b) plans, all of which may offer loans under the same terms. (Loans are not permitted on IRA accounts, including SEP and SIMPLE plans.)
The basic rules on 401(k) loans according to the IRS* are as follows:
- You can borrow up to 50% of the vested balance in your plan.
- The maximum dollar amount you can borrow is $50,000.
- Loans must be paid back within five years. (There’s an exception if the funds are used to purchase a primary residence.)
The first point, referring to vested balance, requires some explanation. All the money you have in your plan that comes out of your own payroll contributions is immediately vested. However, matching contributions to the plan by your employer are subject to a vesting schedule.
The IRS allows two basic vesting schedules*.
Your employer can select either vesting method. But to make the point of how vesting works with a 401(k) loan, let’s assume you’ve completed four years of service, and your employer matching contribution is 60% vested.
If you have $70,000 in your plan, and $40,000 came from your own contributions, with $20,000 employer matching contributions and $10,000 in investment earnings, the vested percentage of your 401(k) plan will look like this:
- Your contributions, 100% vested:$40,000.
- Investment earnings, 100% vested:$10,000.
- Employer matching contributions, 60% vested:$12,000 ($20,000 X 60%).
- TOTAL VESTED PLAN BALANCE: $62,000.
If the entire balance in your plan $70,000 was 100% vested, you could borrow $35,000 against it, representing 50% of the vested balance. But due to your employer’s vesting schedule, your vested plan balance is only $62,000. At 50%, that will give you a maximum loan amount of $31,000.
IRS Rules on Loan Balances Outstanding After Termination of Employment
There are a lot of advantages to taking a 401(k) loan, including automatic qualification, low interest, and the fact that the loan will not appear on your credit report. But a major negative is what will happen if your employment is terminated for any reason, and you still owe on your 401(k) loan.
If your employment terminates, and you’re unable to repay the loan within the specified time requirement, the outstanding loan balance will automatically be considered a distribution. The employer will be required to issue IRS Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. The form will be provided to both you and to the IRS.
As a result, the amount of the distribution (outstanding loan proceeds) will need to be included on your tax return for the year in which the distribution was declared. It will then be subject to ordinary income tax.
But if you’re under age 59 at the time of the distribution, you’ll also be subject to the 10% early withdrawal penalty tax.
Let’s work an example to illustrate the point
Three years ago, you took a $50,000 loan against your 401(k) plan. But you left your employer, with $20,000 remaining outstanding on the loan.
If you’re unable to repay the remaining principal balance out of other assets, the employer will issue IRS Form 1099-R, and you’ll be required to report the distribution on your income tax return.
If you have a combined federal and state marginal income tax rate of 20%, and you’re under 59, the distribution will be subject to tax at a rate of 30%. That will require you to pay an additional tax of $6,000 as a result of the unpaid loan balance.
How Much Time You’ll Have to Repay Your 401(k) Loan
Up until the Tax Cuts and Jobs Act (TCJA) was passed at the end of 2017, but mostly effective for tax returns filed in 2018 and later years, 401(k) loan balances typically had to be repaid within 60 days of termination.
But under the new tax law, you’ll get something of a reprieve. For 401(k) loan distributions that have taken place after December 31, 2017, you’ll have to up until the due date of your tax return for the year of the distribution to repay the loan proceeds.
For example, if you left your job and the distribution of the unpaid loan proceeds took place in January 2020, you’ll have until April 15, 2021, when you file your income tax return for 2020, to fully repay the loan.
Similarly, if the loan distribution took place in December 2020, you’ll have the same deadline to repay the outstanding loan balance - April 15, 2021.
In either distribution scenario, you’ll have the benefit of having more than 60 days to repay the loan. In fact, if you get an extension to file your tax return, the final date to repay the outstanding loan balance can be as late as October 15, 2021.
If you successfully repay the full amount of the outstanding loan balance, no tax or penalty will be due on the loan distribution.
Should You Borrow to Repay a 401(k) Loan?
Given the potential tax liability that could result from an outstanding 401(k) loan balance being reported as a distribution, it might make sense to borrow money from other sources to repay the loan.
Naturally, the amount of the distribution will be a factor affecting your decision to borrow money for repayment. For example, if the amount of the distribution will be $2,000, and it will result in an increased tax liability of $300, it may not be a concern.
But if the distribution will be $10,000, resulting in an increased tax liability of $3,000, borrowing from other sources can make abundant sense.
You’ll naturally want to be very selective about where to get a loan. Here are some options:
If you have sufficient available credit lines, paying by credit card can be a quick and easy way to pay off the loan balance. However, since credit cards have the highest interest rates among loan types, the interest you’ll pay on the credit cards may eventually match or exceed the tax you’ll pay on the distribution. Only use a credit card if you reasonably expect to repay the balance entirely within a few months.
One option may be to use a 0% balance transfer credit card to pay the remaining balance on the 401(k) loan. But first, make sure the 0% offer will cover the 401(k) loan.
These are commonly available at banks and credit unions and come with lower interest rates than credit cards. Just as important, they have a fixed term, which will require you to pay them off within a specific amount of time. The main limitation maybe the size of the loan. Since personal loans are unsecured, the bank may limit the amount to no more than a few thousand dollars. That may not be sufficient to fully pay your 401(k) loan balance.
Apart from banks and credit unions, you can look into online peer-to-peer lending platforms such as Fiona which specializes in personal loans. Two of the most prominent are LendingClub and Prosper. Both offer loans of up to $40,000 for any purpose, which is likely much higher than what you can get on a personal loan from a bank or credit union.
Home Equity Loans
If you’re a homeowner, and you have sufficient equity, you may be able to take a home equity loan or line of credit to pay off the remaining 401(k) loan balance. Since the loans are secured by your home, they typically have very attractive interest rates. The main disadvantage is that it may take years to pay back the loan, which will result in adding substantial interest to the loan proceeds.
Using Loans as a Partial Solution
If you have enough liquid assets available to pay off some of the outstanding 401(k) loan balance, any of the above loan types may work as a partial solution. By reducing the amount of the new loan you’ll be taking, you’ll also lower the expenses related to the financing. It’s not a perfect way to pay off your 401(k) loan balance, but it’s better than borrowing 100% of the amount due.
Always keep in mind that the financing costs involved in borrowing money have the potential to be even higher than the taxes and penalties you’re trying to avoid.
Alternatives to Borrowing to Repay a 401(k) Loan
Obviously, the most cost-effective solution to avoiding the tax consequences of an outstanding 401(k) loan becoming a taxable distribution will be to pay off the loan using liquid assets. Borrowing money from other sources should be held as a last resort. Other alternatives should be considered first.
One is to sell off any personal assets you have that you no longer need. Even if it amounts to only a couple thousand dollars, it will at least reduce the loan balance.
But a better alternative is to take advantage of the extra time available to repay the loan under the new tax law.
For example, if the distribution is issued as of June 2020, you’ll have 16 months to fully repay the 401(k) loan if you extend your tax return to October 15, 2021. You can use that time to save money to pay off the loan.
One way to do that is to forgo making contributions to the 401(k) plan at your new employer until the loan on the old plan is paid in full. Alternatively, you might take a part-time job or do extra work on the side to raise the money to pay off the loan.
If the outstanding loan balance is beyond any of the solutions proposed in this article, the best strategy may be to save money and earn extra income to pay the tax you’ll owe on the distribution.
It’s not a perfect solution, but you’ll need to come up with extra money no matter which way you play it. In the end, simply preparing to pay the taxes or working with an advisor or a service such as blooom may prove to be less involved and stressful than paying off the loan balance itself.
*Read more about the basic rules on 401(k) loans from the IRS here. More information on the IRS basic vesting schedules can be found here.