Can 401k Loans be Paid off Early?
Can 401(k) loans be paid earlier than the five-year amortizing payment schedule? Find out what the IRS says, and the options you have.
A 401(k) loan can be a convenient tool if you are looking for a quick source of cash to pay for emergencies. You can borrow from your retirement savings to pay for college, roof replacement, or to purchase your primary residence. Most employers allow employees to borrow from their 401(k) retirement savings up to 50% of their vested balance up to $50,000.
A 401(k) participant can decide to pay off a 401(k) loan early by making extra payments towards the loan repayment. If the plan requires loan payments to be made through payroll deduction, you can adjust the withholding on the applicable paychecks to increase the loan repayments. 401(k)s do not charge early repayment penalties to participants who pay off the loan early. The loan statement will show the additional credits to the loan account, and the remaining 401(k) loan principal balance.
Basic Rules of 401(k) Loan Repayment
When a participant takes a 401(k) loan, they must observe the time frames provided by the IRS for loan repayment. The IRS requires that borrowers must pay off the 401(k) loan within five years from the time they took the loan. The loan should be repaid in “substantially equal payments” spread over the term of the loan.
An exemption to the 5 years rule is if you took a coronavirus-related loan under the CARES Act. The new act allowed 401(k) participants an extra year to repay the loan subject to the approval of the plan administrator. The act allows borrowers to defer loan payments for an extra year after the lapse of the regular 5-year period. However, the interest on the loan still accrues in the extra year.
How to Pay Down 401(k) Loan Quickly
If you are planning to pay off the 401(k) loan early, the first thing you should do is to check your plan document and loan policy to see what is allowed. Some plans allow 401(k) prepayments if the participant plans to pay off the outstanding balance either as one lump-sum payment or as additional payments above the regular periodic payments.
Depending on what your 401(k) plan allows, you can increase the periodic payments or set aside the extra payments in a savings account until you have accumulated enough balance to pay off the loan in full. If your employer only allows loan payments via payroll deductions, you must adjust the withholding to increase the regular payments. On the other hand, if the employer accepts checks, you can make a lump-sum payment using a check to clear the outstanding balance.
Create a Structured Plan for Repayment
Not all employers offer an automatic option to repay a 401(k) loan. In some cases, the employee is solely responsible for making loan repayments, and this creates a risk of the borrower falling back on loan repayments. If you do not have an automatic loan repayment option, you should create a structured plan on how you are going to repay the 401(k) loan in full.
Start by examining your budget to see how much remains to spend after paying all household bills and outstanding debts. If you know the 401(k) loan term, you can decide how much you will be paying each month to repay the entire 401(k) loan ahead of the required period. If your 401(k) plan only allows prepayments in one lump-sum payment, you can set aside the payments in a savings account every month until you have accumulated enough savings to pay off the 401(k) loan.
Can You Borrow to Repay a 401(k) Loan?
If a 401(k) loan is at risk of being reported as a withdrawal, you can opt to borrow from another source to avoid tax liability. Depending on how much you owe, borrowing a loan could make sense if the potential tax liability is higher than the interest you would pay on the new loan.
For example, if the outstanding 401(k) loan to be reported as distribution currently stands at $20,000, it means that will owe up to $6,000 in federal taxes. In this case, borrowing from other sources to evade the tax liability could make economic sense. You can use a 0% balance transfer credit card, home equity loan, or other types of loan to pay off the 401(k) loan at a considerably lower interest.
However, if you have a $1000 401(k) balance and there is a potential tax liability of up to $200, you can voluntarily default on the 401(k) loan and offer to pay the federal taxes before the tax deadline of the following year.
What happens to a 401(k) Loan after the termination of employment?
Once you have left your job, whether voluntary or involuntary, your employer will require you to pay off any unpaid loan balance within a defined period. The situation can be worse when the termination is unexpected, and you have a large unpaid 401(k) loan balance that could generate an unexpected tax bill. If the loan is not repaid within the required period, the outstanding loan balance will be deducted from the participant’s 401(k) account to offset the balance.
Unless you come up with a sufficient amount and put it back into the qualifying 401(k) account within the required period, the distribution will be taxable. This means that the participant will be taxed as if the outstanding loan were a cash distribution or withdrawal. The employer will issue you with IRS Form 1099-R, and a copy of this form will be sent to the IRS. If you are under 59 ½ when you leave your job, you will also pay a 10% early withdrawal penalty over and above the income taxes.
How Long Do You Have to Repay 401(k) Loan if you Quit?
Before the enactment of the Tax Cuts and Job Act in 2017 (TCJA), 401(k) participants were required to pay off any outstanding loan balance within 60 days of leaving the employer. Otherwise, the unpaid loan balance was considered a distribution and taxed at the participant’s tax bracket rate.
With the enactment of the new law, 401(k) participants have until the tax due date for the year when the distribution is made to repay the outstanding 401(k) loan. For example, if you left your job in January 2021, you will have until April 15, 2022, to fully repay the loan. Once you have settled the outstanding 401(k) balance, you will not be required to pay tax or penalty on the distribution.