June 15th, 2020
What to Expect if you have a 401(k) Loan and Lose your Job
So perhaps you’ve asked this question: Why pay someone else interest when you can pay yourself interest with a 401(k) loan?
Vanguard’s 2019 “How America Saves” report shows that 13 percent of 401(k) savers have an outstanding loan. Federal law allows workers to borrow up to 50 percent of their account balance with a maximum of $50,000 (the CARES Act temporarily increased that to $100,000 for individuals financially impacted by the coronavirus pandemic). The loan is tax-free and, unlike with most outright distributions, there’s no early withdrawal penalty of 10 percent if you’re under age 59½.
Reasonable minds can differ on whether these loans, which typically have a five-year repayment term, are sound financial endeavors.
Yet let’s assume your 401(k) loan was working well for you and you were repaying it with your paycheck as planned. Then, like almost everyone, you didn’t see Coronavirus coming and, like way too many, you lost your job amid the pandemic. Here are the rules for what happens next if you find yourself in that situation.
Let’s start with the bad news. The borrowed money could generate a tax bill you weren’t expecting. Generally, if you leave your job — whether by choice or not — 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 taxable distribution. In essence, the loan becomes almost immediately due. Then, if not repaid, it morphs into a cash distribution, which reduces your savings and comes with taxes and an early withdrawal penalty.
Although recent economic rescue legislation provides relief for coronavirus-related withdraws from 401(k) plans, loans that already existed are subject to preexisting rules that apply when you part ways with your company. The CARES Act made 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 — but the legislation does not cover loans unrelated to the current crisis. That includes ones that already were outstanding when Coronavirus struck.
These are the rules for now. Let’s hope Congress broadens relief to make whole those who fairly expected their pay checks would continue before Coronavirus.