Can you take a 401k loan while unemployed?

When you are out of employment and with no other source of income, it is natural to think about accessing the 401(k) money to meet your needs. While you could be receiving unemployment checks from the governments, these funds may not be enough to cover your expenses such as utility bills, gas, clothes, food, essential products supplies, mortgage payments, etc. Depending on your situation, you could consider taking a 401(k) loan to relieve your burden.

If you recently became unemployed, your former employer may not allow you to take a 401(k) loan. Once you leave your job, you will no longer receive paychecks that the employer can deduct to pay the loan. Instead, you will be solely responsible for making loan payments. Hence, you will become more of a credit risk, and the former employer will be hesitant to approve the 401(k) loan if you are no longer an employee of the company.

How 401(k) Loans Work

Usually, most 401(k) plans, if not all, make 401(k) loans exclusively available to current employees of the company. This protects the 401(k) plan against loss in the event that the participant defaults on the loan. When an employee receives a 401(k) loan, the 401(k) plan automatically deducts the loan payments from the employee’s paycheck. This ensures that loan payments are made on time since the deduction is made before the funds reach the employee.

If the employee quits or leaves the employer with an unpaid loan, they must pay off the outstanding balance before the tax due date. In this case, the employee will be solely responsible for the loan repayment, and this increases the risk of default. If the outstanding loan amount is not fully paid by the tax due date, it will be considered to be a distribution, and you will owe income taxes, and a potential penalty if you are below 59 ½. 

Alternatives Methods of Accessing Your 401(k) Money

If you are unable to get a 401(k) loan due to your unemployment status, you can still tap into your retirement savings in the following ways:

Hardship Withdrawals

If you have an immediate and heavy financial need, you may qualify for a hardship withdrawal. Depending on the individual 401(k) plan, the plan sponsor may decide whether or not to allow a hardship withdrawal. If your 401(k) plan allows these withdrawals, you may need to meet certain guidelines and provide evidence of the hardship you are facing. You will still owe income taxes, in addition to a penalty tax if you are below the required retirement age.

During the COVID-19 pandemic, the CARES Act increased the withdrawal amount from $50,000 up to $100,000 for the year 2020. This distribution was treated as a safe-harbor distribution that was exempted from the 10% penalty tax if you are below 59 ½. Also, instead of paying income taxes by the tax due date, the CARES Act allowed individuals to spread out the taxes for a period of up to three years.

Rule of 55

If you were laid off in the year you turned 55, you can take a 401(k) distribution without paying an early withdrawal penalty. The IRS allows individuals who become jobless at age 55 to take a penalty-free distribution, without having to wait until they are 59 ½. If you have other old 401(k)s left with former employers, you may still access these funds penalty-free. However, you will still owe income taxes on the amount of distribution you take.

Substantially Equal Periodic Payments (SEPP)

If you are below age 59 ½, you can use the SEPP method to access your 401(k) money without penalties. Usually, withdrawing money from a 401(k) before you are 59 ½ attracts a 10% early withdrawal penalty. With a SEPP plan, you can withdraw funds from a 401(k) through specific annual distributions for a period of up to 5 years, or until you turn 59 ½. You can take multiple withdrawals from the retirement account, as long as the total sum withdrawn does not exceed the predetermined annual value. The annual value is determined based on the participant’s life expectancy.

60-day Rollover Period

Once you leave your job, you can roll over the 401(k) money to an IRA to take advantage of the 60-day rollover period. You can use an indirect rollover so that the plan administrator mails you a check with your 401(k) balance. You must then deposit the funds to an IRA within 60 days. If you need the money in the short-term, you can utilize the rollover funds as long as you deposit the full amount before the 60-day period ends. If you don’t rollover the money to an IRA or other qualified retirement account within the 60 days, the IRS will consider the amount as a distribution, and you will owe taxes on the full amount.