401(k) Loan Payback Options- If You Change Jobs
401(k) Loan Payback Options- If You Change Jobs
401(k) plans are an easy, convenient way to save for retirement. Set up through your workplace, a percentage of your paycheck is contributed to the plan automatically each paycheck. Some companies even help out by adding a matching contribution. The money can be withdrawn at age 59 1/2. Most 401(k) plans allow for a loan option, if you had a ‘need’ you could borrow from yourself, instead of from a credit card or bank. Today we’re going to discuss what’s the effect of a loan from your 401(k) and taxes if you voluntarily or involuntarily leave your job.
Here are the basic 401(k) loan rules
- You can borrow up to 50% of the vested balance* in your plan.1
- 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.)2
*Any money you contribute is automatically vested, matching contributions to the plan by your employer may be subject to a vesting schedule.
Depending on the holder of the plan you have a few workable options
#1 Pay up
They may give you a time period to repay the 401(k) loan otherwise the plan is required to issue IRS Form 1099-R. Generally, you will have until your tax return is due to repay the loan, including extensions, October 15th each year.
#2 Loan Offset
They may reduce your vested balance which is called a loan offset
The loan offset could have tax consequences involved. The loan will be treated as a distribution and subject to tax. The tax will be at your current tax bracket, plus if you’re under age 59 and a half, you’re going to be penalized 10% by the IRS for an early withdrawal. The amount could push you into a higher tax bracket.
#3 Borrow To Repay
There are a variety of options to consider borrowing from to repay your 401(k) loan.
- Credit Card
- Home Equity Loans
- Personal Loans
#4 Convert 401(k) to an IRA
After separation from an employer, you can roll your 401(k) plan into an IRA account. IRA accounts are available from banks, investment firms, or insurance companies. This option may give you more time to pay back your loan. Let me explain: normally you would have 60 days to pay back any withdrawals (or loans) from a 401(k), but with the 2017 Tax Cuts and Jobs Act, Congress extended the 60 days to the due date, plus extensions, of your federal tax return filing for the year the loan takes place. You would gain more time to pay back your 401(k) loan by using this extension
Let’s work on an example to illustrate the point…
Example: Maja, age 45, loses her job on March 13, 2021, she has a $53,432 401(k) account balance and a $10,000 outstanding loan balance. Maja is unable to repay the loan. She elects a direct rollover of her 401(k) into an IRA. On April 15, 2021, the plan offsets her $53,432 account balance by the $10,000 loan balance and transfers $43,432 into her IRA.
Maja has until October 15, 2022 (tax extension deadline) to replace and roll over the $10,000. Otherwise, she will have an additional taxable income of $10,000 and a $1,000 (10%) IRS Penalty.
If you successfully repay the full amount of the outstanding loan balance, no tax or penalty will be due on the loan distribution.
If you meet the definition of ‘qualified individual’ under the CARES Act, you can treat a 2020 loan offset as a coronavirus-related distribution (CRD).3 This gives you three years to pay back the loan and roll it over to the IRA. If you were unable to repay the loan the amount would also be exempt from the 10% early distribution penalty, and you could spread the taxable income over three years.
Since 401(k) plans are contributed to pre-tax, be cautious when making any changes or withdrawals. I explain some common mistakes in this blog.
If you have questions about this situation or any other financial situation, we would love to hear from you. You can reach us at www.Resourcecenterinc.com or you can call the office 882-1800, and I’ll be glad to sit down and visit and we can talk about it. To set up a call on my calendar click here.
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