What Happens if I Have a 401(k) Loan and Quit My Job?
Outstanding 401(k) loans can cause problems when employees quit a job. Along with changing jobs, employees have to deal with what to do with their 401(k) loan.
When faced with a difficult financial decision, it can be tempting to want to tap into your 401(k). However, income tax and IRS early withdrawal penalty tax can eat into your retirement savings and the amount you keep. A 401(k) loan can be a great alternative because it allows you to withdraw money from your 401(k) and avoid taxes and penalties. That money is repaid back into your 401(k) account, and your retirement funds continue to grow over time. But if you quit your job or get fired, you may find yourself in an even bigger mess.
If you quit your job with an outstanding 401(k) loan, the IRS requires you to repay the remaining loan balance within 60 days. Fail to repay within that time, and the IRS and your state will deem the balance as income for that tax year. You’ll need to pay income tax and face a 10% penalty tax in addition. If you spent the entire allotment of funds, that tax and penalty will need to be made up before April 15h of the following year.
How do I get a 401(k) loan?
Not all, but most employer-sponsored 401(k) plans allow their participants to take out 401(k) loans. It is an excellent way for employees to tap into their retirement funds without paying income taxes and early withdrawal penalties.
If your 401(k) plan utilizes an online portal to do the operations of its accounts, you can apply for a 401(k) loan from there. This option usually is the quickest as it doesn’t have to go through a person to facilitate the loan process. From application to approval, it can take anywhere from a couple of business days up to a week.
401(k) plans that don’t have an online presence can still offer 401(k) loans. You’ll need to contact your plan’s administrator or human resource department and complete an application form. This process may take a little more time since a person will need to review your documentation and grant an approval.
You’ll have two options to receive the proceeds of your 401(k) loan, either by check or by direct deposit. A direct deposit is the fastest way to get your funds in your hands. Once the loan is approved, the funds will automatically be processed and should get into your bank account between two and five business days, depending on your bank. However, if you choose to receive a physical check, it can take upwards of two or three weeks. Once the loan is approved, the plan’s administrator will need to process the physical check and mail it to you. Then, the check will need to navigate the mail system and make it to your house. Finally, you’ll need to deposit the check into your bank account, which could add a few more days to your timeline.
What are the terms of a 401(k) loan?
The terms of a 401(k) are usually set by the plan’s administrator. However, there are some IRS regulations that must be followed in order to stay compliant.
The IRS caps 401(k) loan amounts to the lesser of $50,000 or 50% of the 401(k) account balance. Additionally, the IRS requires 401(k) loans to be repaid within a five-year term. However, due to the COVID-19 pandemic and the subsequent legislation to help American’s that five-year term has been extended to six years. It’s essential to check the most recent information or discuss it with your plan’s administrator if you can extend the repayment term length.
The interest rate on a 401(k) is typically a point or two above the prime interest rate at the time of application. Remember, the interest you repay towards your 401(k) loan goes back into your 401(k) account. Think of it as you’re paying yourself back as the bank for taking the loan out.
Lastly, your plan’s administrator may charge fees for you to take out a 401(k) loan from their plan. Typical origination fees range between $50 and $100. Some 401(k) plans charge a monthly maintenance fee throughout the term of the 401(k) loan of $25 to $50.
What happens if I leave my job with an outstanding 401(k) loan?
Leaving a job, whether by quitting or getting fired, is always a stressful time. Parting ways with a company with whom you have an outstanding 401(k) loan can cause even more problems.
Regardless of how long you have left on a 401(k) loan, the IRS requires 401(k) loans to be repaid within 60 days of leaving an employer who sponsors the plan in which you took a loan out.
Borrowers who fail to repay the remaining balance within 60 days will be required to pay income tax on the amount at the applicable tax rate. Additionally, a 10% early withdrawal penalty tax will be assessed as the IRS will deem the unpaid portion as an unqualified 401(k) disbursement.
If you’ve spent the entire amount you received from your 401(k) loan, this amount will need to be made up by April 15, when taxes are due.
To avoid any taxes or penalties, you could take out a personal loan depending on the outstanding amount. This method would essentially extend the repayment period and avoid having you come up with a lump sum on your own.
Additionally, if you have made enough contributions to a Roth IRA to cover the outstanding balance on your 401(k), you may be able to withdraw the amount you need tax and penalty-free. Withdrawals of Roth IRA contributions are not considered ineligible distributions as those contributions were already taxed prior to them being deposited into the Roth IRA.