Changing Jobs? Should You Borrow to Repay a 401k Loan?

One of the features of many 401k retirement plans is that you can borrower money from your own account. While 401k plans are not required to permit plan participants to take out loans, many plans do. Much has been written about the pros and cons of 401k loans. One of the potential drawbacks comes into play if you leave your job (voluntarily or otherwise) while you still have an outstanding loan from your 401k plan.

When this happens, you generally have two options: (1) pay back the loan in full within 60 days, or (2) don’t. If you follow option (2), however, the IRS will treat the loan as an early withdrawal from your 401k plan, and with some exceptions, smack you with a 10% penalty of the outstanding loan amount AND require you to pay taxes on the distribution. Thus, you could easily end up paying 30% or 40% of the outstanding loan amount in penalties and taxes. It goes without saying that failing to payback the loan can be a costly decision.

The problem that often arises, however, is that folks want to pay back the 401k loan, but can’t afford to do so. Particularly in difficult economic times, many people are let go and lack the available funds to repay the loan. And that raises an important question–should you borrow to repay a 401k loan?

The short answer, in my opinion, is absolutely yes. And to my surprise, it’s also Dave Ramsey’s advice, and we all know how much he preaches against non-mortgage debt. Between the taxes and penalties you’ll owe if you don’t repay the 401k loan, the cost will almost always be greater than a short-term loan at reasonable rates to repay the 401k loan. In addition, by not repaying the 401k loan, you forever remove that money from your retirement investments, thus losing the tax-deferred return on your 401k investments forever.

But the question still remains, where should you look to borrow money to repay a 401k loan? Here are a few alternatives:

  • Home Equity Line of Credit: Perhaps the first option would be to tap a home equity line of credit. Equity lines generally come with reasonable interest rates and are easy to access.
  • 0% Balance Transfer cards: Another potential option is to take advantage of one or more 0% balance transfer offers. Before going this route, however, make sure you can pay off a 401k loan with the balance transfer card. Also keep in mind that the introductory rate periods are now generally just 6 months. After that, the interest rates adjust to whatever regular APR applies to the card.
  • LendingClub: LendingClub offers unsecured loans up to $25,000. Depending on your credit history, credit score, and other factors, you can obtain a loan at a reasonable interest rate. All loans must be repaid over three years, although you can chose to pay off the loan sooner.
  • Unsecured Line of Credit: You can obtain unsecured lines of credit from most banks and credit unions. Interest rates will vary significantly based on your credit history. I have an unsecured line at Citibank that I rarely use, but it does come in handy for short-term loan needs.

So what’s your take? Should you borrow to repay a 401k loan if you don’t have the funds available to repay the debt?


Topics: Personal Finance

20 Responses to “Changing Jobs? Should You Borrow to Repay a 401k Loan?”

  1. varunee browder

    I had borrowed from my 401 k to pay my high interest credit card during my husband secound laid off for 11months, with 2 childrens in school, we depleted our saving.I need to pay some of my high interested credit cards off, so I can affort to make other payment and take care my family. I did have plan to change job, so i called the company 401 plan and the adviser told me that I can continue to make the payment by set up the checking acct. so they can withdraw from them each month automatic.When i change the job, and i did what I was told, the 401k plan send me the paper that I need to pay off total amount with in 2 months, otherwise i have to pay the tax and penilty, and they siad they are sorry that their employee gave me the wrong advised. My ignorant and trust to the company’s financial adviser that they know what they doing bacause I don’t.I have fairly decent education and like to prepare ahead,what about other people whom don’t have that opportunity? I hope the government understand that some people work hard to make a living honestly never get the break. why is that?

  2. “Debbie stanovcak says:
    June 30, 2015 at 10:52 am
    My husband left a job with an outstanding 401kloan. The company took the amount owed on the loan from his 401kloan account to pay off the loan, why?”

    What? What you are saying doesn’t even make sense.
    The company your husband worked for used money from his 401k account to pay off his 401k loan? Hardship loan maybe? I mean, come on, you HAVE to have more information than this.

  3. jamey beavers

    Debbie what your saying makes perfect sense. Where i work you can borrow up to half of what you have in your account so the other half is like collateral if you leave the company.

    • Chris Watson

      This is not correct. The money you borrowed from your 401k is your money whether you pay it back or not. If not you are subject to the tax penalty and regular taxes as if you had received that same money as income. There is no way that any employer can take money from your 401k to satisfy a loan that you have taken from the 401k. You have not borrowed from the employer. You have borrowed from yourself. This should be investigated as a legal problem. Its not collateral at all. That is not how a loan from 401k works.

  4. So how does that work? If the company takes the money from your 401k to pay your loan, the loan was to yourself, so does that money go back into the 401k, In other words do you still have that amount from the loan back into your 401k?

    • Stephanie Colestock
      Stephanie Colestock

      Terry,

      If you take out a 401k loan, it will come directly out of your 401k (tax-free) and be paid out to you. Then, you will repay it over a period of time back into the 401k — but you’ll also pay yourself interest on the loan (which also goes into your 401k account). So, yes, you’ll still have that money in the end (plus interest) after you finish repaying the loan.

  5. Hello, I was looking to see if my questions was already answered here, but it was not quite clear. So I took out a 401k, if I leave my company can the loan be deducted from the positive balance from my 401k. For example, I took out t $6,000 loan and my current balance is $46,000. So could they just distribute or roll-over $40,000? Thanks.

    • Stephanie Colestock
      Stephanie Colestock

      Karen,
      Unfortunately, you will actually need to pay back what you borrowed against the 401k. It cannot simply be deducted against your balance without penalty.

      Typically, you’ll have 60 days after leaving the company to repay the loan in full if you want to avoid it being counted as a taxable distribution (which would then be reported on a 1099-R). If you’re younger than 59.5, you’ll also have to worry about an additional penalty (of 10%) for taking an early distribution, if you don’t pay it back before the deadline.

      Best, Stephanie

  6. So I quit my job and was paying back on a 401k loan, I have almost $900 more in my 401k account than what I owe, I am going cash out on it because of my new job I don’t get paid until 45 days after I started and need the cash. My question is when i cash out will I get my full amount in my account or will they deduct what I owe on my loan and give me the almost $900 that’s left after the loan ? And what penalties will that cause during income tax time ? T.I.A !

    • Rob Berger

      Rose, typically if you cash out a 401k before you are 59 1/2, you pay a 10% penalty + taxes. There are exceptions to this rule, however, so you should consult a tax professional before making a final decision.

  7. Veronica, they will deduct what you owe and that $900 will probably be eaten up by penalty fees for not paying back the loan. Basically transforming it to a withdrawal. Then you will have to claim the amount leftover on the loan as income so you will be taxed again depending on your tax bracket.

  8. I have a question and I hope someone can answer it. I plan on leaving my job mid December next year after I am out of school. I will still owe around 1800 on my 401K, and I should have around 6000 in my 401K around the time when that comes, as well was over 3000 in My profit sharing plan. The plan is to start my own business and cash out the rest of the money from the 401K and profit sharing plan to live off of while I get everything off the ground. By that point in time I should probably have 3 or 4000 in my savings account. Should I pay off the loans and then cash out the 401K and profit sharing or just have them deduct the remainder and take their cut?

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