How to Pay off 401(k) Loan Early?

If you need urgent cash for a financial emergency, a 401(k) comes as a relief, and you can borrow on your accumulated 401(k) savings at favorable terms. Taking a 401(k) loan equates to borrowing from yourself, and the interest you pay on the loan adds up to your retirement savings. Usually, a 401(k) loan has more favorable terms than a regular bank loan, and it is a good alternative if you do not want to withdraw your retirement money.

If you are currently paying off a 401(k) loan, you can choose to pay off the outstanding loan balance earlier than the allowed loan term. Some of the ways you can use to pay off the 401(k) loan early include making extra payments, rounding off loan payments, borrowing to pay the loan, taking up a second job, and selling idle personal assets to raise money to pay off the debt.

Ways to Repay Off 401(k) Loan Early

If you are unable to repay the 401(k) loan, there is a potential tax liability if the plan administrator reports your account as a distribution. To avoid this situation, you can use either of these options to repay your 401(k) loan quickly:

Create a Structured Plan for Repayment

If you don’t have an automatic repayment option for your 401(k) loan, you should reorganize your budget to determine how much cash you have left. You can create a repayment plan that allows you to make higher payments in periods when there is surplus cash left to spend. This will help you pay off the loan in a shorter period than the actual loan term.

Make Extra Payment

Making one or more extra payments towards your loan can help you pay off the balance sooner. If you pay $300 towards your loan, you can make an extra $300 payment every month to reduce the balance. For larger payments above $1000, you can make the extra payment every few months or quarterly to reduce the amount due every year.

Round off Your Payments

Rounding off your payment to the nearest hundred or thousand is a smart way to shorten the loan term. For example, if you are paying $330 towards the loan every month, you can round off the payment to $400. The extra payment will amount to $840, which is enough to knock two and half months from the loan term.

Use Your Savings

If you have a separate saving account with extra money, you can take out part of the cash to pay off part of or all of the outstanding loan balance. This will help you avoid a tax liability, which would be an extra expense for you. Once you’ve settled the 401(k) loan, you can direct the amount you would have paid as loan payments to the savings account.  

Borrow from Other Sources

You could also consider borrowing from other sources to repay the outstanding loan balance. You should weigh the cost of borrowing vs. the withdrawal tax liability when you default on the 401(k) loan to determine what decision to take.

For example, if you have an outstanding balance of $10,000, you may be required to pay up to $3,000 in taxes and penalties. Assuming that you can borrow $10,000 at 10%, the cost of borrowing will be $1000, which is $2000 less than the arising tax liability. Therefore, it will make economic sense to take a loan and repay the 401(k) loan. 

Borrowing money from other sources should be the last resort. You can take a personal loan, credit card debt, or home equity loan.

Sell Personal Assets You Do not Need

If you have personal assets that you no longer need, you can sell them to raise enough money to pay off the remaining balance. For example, if you can sell assets such as furniture, piece of art, jewelry, etc., and use the proceeds to pay the debt.

Take Up a Part-time Job

If your budget is too squeezed to afford another payment, you can take up a second job to earn extra income to pay the 401(k) loan. You can also start a consulting business or a freelance job, which you can do on a part-time basis. This will help you raise a few thousand dollars every month to pay off the outstanding loan in a shorter period.

Forgo Making Contributions at the New Employer

If you recently changed jobs, your plan administrator may allow you some time to clear off the remaining balance. You can forgo making contributions to the new employer’s 401(k) and redirect the contributions towards your loan repayment to reduce the 401(k) balance. This will free up cash once you’ve paid the entire debt, and increase your contributions to the new 401(k).

Cash-out

Cashing out your 401(k) is a less desirable option, but it could be an option if a 401(k) is causing you unnecessary stress. You can withdraw part of your retirement savings to settle the outstanding 401(k) balance. However, this will cost you additional costs in terms of taxes, penalties, and your retirement income

How Long Do You Have to Repay 401(k) Loan?

Generally, 401(k) plan administrators allow up to 5 years for participants to repay their 401(k) loan. The IRS requires that 401(k) loans should be paid in equal periodic installments that include the principal and interest. You can also opt to pay the outstanding balance through payroll deductions.

If you are using the 401(k) loan to purchase your primary residence, you may be allowed a longer repayment period depending on the amount of the loan. Check with your plan administrator to know how much time is available to repay a 401(k) loan.

What Happens to a 401(k) When You Quit or Change Jobs?

When you change jobs with an outstanding 401(k) loan, you must continue paying the balance until it is fully paid. Before the Tax Cuts and Jobs Act (TCJA) was passed in 2017, 401(k) loan borrowers had 60 days after leaving the employer to clear the outstanding balance. Under the TCJA law, you have until the due date of your tax return to repay the loan balance. For example, if you took a 401(k) loan in February 2021, you have until April 15, 2022, to repay the 401(k) loan fully.

If you are unable to repay the loan before the due date, the plan administrator will report the outstanding loan as a distribution. The loan balance will be considered a taxable income, and you will owe income taxes, and 10% penalty tax for early withdrawal if you are below age 59 ½. In this case, the employer will issue Form 1099-R to the IRS, and you will be required to report this amount in your tax return for the year.