This post was originally published on this site
Dear Dan,
I took out a loan against my 401(k) last year and was on a five-year payback plan through my biweekly paycheck. I’ve been offered a new job at another company. How do I pay back that loan when I stop getting that paycheck? Just send a check every month?
—Karen in Birmingham
Dear Karen,
Payback is determined by your plan. The provisions that govern loans will be found in the Plan’s Summary Plan Description (SPD). It does not matter if you quit or are fired, the loan must be handled. I would be sure to know how exactly the plan treats outstanding loans before you resign to work elsewhere. You may still make the move, but you don’t want to be surprised.
The most common surprise is that most companies do not allow paying in installments when you leave. They expect full payment within a short period of time from the end of your tenure. This trips up a lot of people because if they had the money, they likely would not have taken the loan. When a loan is not paid off, the outstanding balance is treated as a distribution.
Federal law does not require plans to allow loans, but many plans include loans in their plan documents. Federal law does layout particulars for plans that opt to allow loans. Generally, workers may borrow half their account balance up to a maximum loan of $50,000. In response to COVID-19 that cap was temporarily increased to $100,000 for loans resulting from COVID-related issues, so some workers have even higher balances.
When a loan is taken, the worker is not taxed when they receive the funds. Interest is charged and the loan is paid back using the worker’s after-tax wages with five-years being the typical term. You will read about how this isn’t so bad because you “pay the interest to yourself.” Sometimes that dynamic can make the loan’s effects less problematic.
Careful: Some plans require that the loan payoff supersedes contributions to the plan meaning that if you take out a loan and remain employed at that company, until the loan is satisfied, no money goes into your retirement savings including company matching funds. This makes taking a loan from a plan a potentially expensive cost against one’s future retirement so check your SPD.
Loans can be risky, too. As mentioned earlier, it doesn’t matter if your job change was your idea or your employer’s. If the loan is not paid back on time, your account balance is reduced by the amount of the outstanding loan and this “loan offset” is considered a distribution. If it were not treated as a distribution, workers could take loans and default without paying any taxes on the funds received.
That loan offset amount is taxable in the year it is deemed a distribution and if you are younger than 59 ½, the traditional 10% penalty for early distribution will also apply. Depending on your tax bracket, that typically means a tax bill due to Uncle Sam of about a quarter to more than half of the loan balance.
If you were to leave your job today and have the balance deemed a distribution, the income would appear on the 2023 1099-R your former employer’s plan would send you in early 2024. Fortunately, due to a major tax code change in 2018, if you can come up with funds by your tax filing deadline (including extensions) in 2024, you can put those funds in an IRA or another eligible retirement plan as a special form of rollover and avoid the tax.
Between the costs to one’s future retirement and the risk of a tax bill, most people find plan loans unattractive relative to other borrowing options.
If you have a question for Dan, please email him with ‘MarketWatch Q&A’ on the subject line.
Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo serving clients nationwide from offices in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some reader questions are edited to aid the presentation of the subject matter.
