Personal Finance

What to expect if you have a 401(k) loan and lose your job

Key Points
  • 13% of 401(k) savers have an outstanding loan, according to Vanguard's 2019 How America Saves report.
  • If you lose your job, there's a good chance your plan will either require you to repay the loan fairly quickly or will end up reducing your account balance by the amount owed and consider it a distribution.
  • Here are the rules for what happens next if you find yourself in that situation.
by Schneider-Photographie

If you already are paying on a loan from your 401(k) account and lose your job amid the coronavirus pandemic, that borrowed money could generate a tax bill you weren't expecting.

Although the latest round of economic rescue legislation provides relief for coronavirus-related withdrawals from 401(k) plans, loans that already have been in repayment are subject to some existing rules that apply when you're laid off or otherwise part ways with your company. In other words, your loan could morph into a distribution that comes with taxes and an early withdrawal penalty.

"If an individual is laid off, it can speed up the time of repayment," said Will Hansen, executive director of the Plan Sponsor Council of America. 

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Although the CARES Act makes some changes to 401(k) withdrawals and loans for individuals financially impacted from the coronavirus — including waiving early withdrawal penalties and giving qualifying individuals three years to replace what they took out — the legislation does not cover loans unrelated to the current crisis. That includes ones that already were outstanding.

As the coronavirus pandemic continues running roughshod over the U.S. economy and job losses continue to mount, some workers may hit the unemployment line with a 401(k) loan in tow. Vanguard's 2019 How America Saves report shows that 13% of 401(k) savers have an outstanding loan.

The average balance on those loans is $9,900 and is most common among workers with income from $30,000 to $100,000. About 78% of plans allow such loans, whose repayment terms are usually five years.

Federal law allows workers to borrow up to 50% of their account balance, with a maximum of $50,000 (the CARES Act temporarily increased that to $100,000 for individuals who are financially impacted by the coronavirus pandemic). The loan is tax-free and, unlike with most outright distributions, there is no early withdrawal penalty of 10% if you're under age 59½.

However, if you leave your job — whether by choice or not — there's a good chance your plan will require you to repay the money back fairly quickly; otherwise, your account balance will be reduced by the amount owed and considered a distribution.

Unless you are able to come up with that amount and put it in a qualifying retirement account, that distribution is taxable. And, if you are under age 55 when you leave the job, you'll pay a 10% early withdrawal penalty. (Workers who leave their company when they reach that age are subject to different withdrawal rules for 401(k) plans).

"A participant who does not repay an outstanding loan will be taxed on the loan as if it were a cash distribution," said Marcia Wagner, founder of The Wagner Law Group and an expert in employee benefits.

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You get until tax day the following year to replace the amount — i.e., if you are laid off in April 2020, you get until April 15, 2021, to come up with the funds. Prior to major tax law changes that took effect in 2018, participants only had 60 days.

Although most plans won't let you continue paying the loan after you leave the company, it's worthwhile checking on the policy for your 401(k) plan.

"There are some plans that let you continue to repay the loan even after termination," said Brian Pinheiro, a partner in the Philadelphia office of law firm Ballard Spahr and an expert on federal retirement law.

For retirement savers who remain employed but are struggling to make payments on their 401(k) loan, the CARES Act allows you to defer payments for one year.

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