Can a 401(k) Loan Be Forgiven?
If you don’t pay your 401(k) loan, it will go into default. But unfortunately, it won’t be forgiven.
If you’re sitting on a sizable 401(k) balance, you may be tempted to tap into it to pay for a big purchase. While not usually advisable, a 401(k) loan can help get you out of a tough financial spot or bridge the gap between financial transactions.
But the rules and guidelines regarding 401(k)s can put you at risk of footing the bill within a very short time. Fail to meet your end of the bargain, and you may find yourself in a worse position than you were in before you took out the 401(k) loan.
A 401(k) loan can’t be forgiven. If you default on a 401(k) loan, you won’t have to repay the outstanding balance, but the IRS will consider the 401(k) loan as an early retirement withdrawal. Subsequently, you’ll be hit with a 10% penalty tax on top of income tax. And tax debt can’t be forgiven or discharged through bankruptcy.
It’s important to understand the potential risks before taking out a 401(k) loan. Sure it can stop the bleeding and get you out of a pinch, but understanding the risk will help you decide if it’s worth it.
Let’s go into 401(k) loans in a little bit more detail—how they work and what happens if you don’t pay.
How do 401(k) loans work?
Most 401(k) plans allow you to borrow against your 401(k). Whether or not your plan allows 401(k) loans will be provided in the plan’s summary plan description.
The IRS allows 401(k) loans up to $50,000 or 50% of your 401(k) balance, whichever is less.
Additionally, the IRS requires all 401(k) loans to be repaid within five years from the time you took the loan out. As a result of legislation due to the COVID-19 pandemic, the IRS has extended repayment of 401(k) loans to six years.
Applying for a 401(k) loan is fairly simple. You can apply through your plan’s administrator or through your online account—if you have one. It may take a few days to finally get approved, but in most cases, you’ll be approved—you’re borrowing your own money after all.
401(k) loans don’t affect your credit in any way. There aren’t any credit checks since your remaining balance is used as collateral. And if you don’t pay, the loan will just be deemed as an early retirement withdrawal.
Repaying your 401(k) loan is effortless as well. Most 401(k) plans require your loan payments to be automatically deducted from your paychecks. This automation allows your payment to be made before you even touch your money.
Finally, the interest you pay towards your loan goes back into your 401(k) account instead of another institution. However, payments made toward your 401(k) loan are made with after-tax earnings—meaning you’ll lose your tax-deferred benefits.
What happens when you leave your job with an outstanding 401(k) loan?
401(k) loans can be a big help if you’re unable to secure financing elsewhere. They’re easy to be approved, payments are simple, and you pay yourself back. However, if things don’t go according to plan, a 401(k) loan can turn into a big mess.
If you quit your job or get fired with an outstanding loan, you’ll need to repay the entire balance fairly quickly.
Traditionally, 401(k) loans had to be repaid with 60 days of termination. However, The Tax Cuts and Jobs Act of 2017 extended the repayment window. After 2018, if you leave your job with an outstanding 401(k) loan, you’ll have until the due date of your federal income tax return, including filing extensions, to repay the outstanding balance.
What happens when you default on a 401(k) loan?
If you leave your job with an outstanding 401(k) loan and fail to pay, the loan is considered default. However, instead of dealing with creditors and debt collectors, you’ll have to answer to the IRS.
Because the IRS considers unpaid 401(k) loans as early retirement withdrawals, you’ll need to pay income tax on the 401(k) loan amount. Additionally, you’ll be hit with a 10% penalty on the amount adding significant costs to your 401(k) loan.
For example, if you take out a $10,000 401(k) loan and don’t pay, you’ll immediately be hit with a $1,000 penalty tax. If you’re in a 15% tax bracket, you’ll owe an additional $1,500 in income tax. Just like that, your $10,000 has turned into $7,500.
And depending on how much you owe, the tax amount will need to be paid on the next quarterly tax payment date. If you end up owing too much when you file your taxes, you could be hit with another tax for not filing estimated taxes throughout the year.
Can a 401(k) loan be forgiven or discharged in bankruptcy?
Because the penalties for not paying back your 401(k) loan are tax-related, they stay with you for life.
IRS tax debt can’t be forgiven. It can’t be discharged through bankruptcy. The only way to get rid of tax debt is to pay up.
This is a huge factor when choosing a 401(k) loan over a traditional loan. Sure, you don’t plan on defaulting on your loans, but we can’t predict the future. It’s better to have the option of bankruptcy or collections settlements than dealing with the IRS for the rest of your life.
Consider rolling over your old 401(k)s
This will boost your 401(k) balance and allow you to borrow more if you need the extra funds.