What Happens If I Leave My Job with a 401(k) Loan?

What Happens If I Leave My Job with a 401(k) Loan?

401(k) loans are attractive because you don’t need to have good credit, you enjoy low interest rates, and you pay interest to yourself instead of a creditor. 

However, if you don’t take time to understand the details, it may end up costing you more than you bargained for and hurt your retirement savings – especially if you leave your job or are terminated before you pay it all back.  

The Great Resignation has seen millions of workers quit. In fact, 25.6 million people quit their jobs within the last half of 2021

The trend is expected to continue well into 2022. 

A recent ResumeBuilder.com report showed one-fourth of workers are looking for a new job this year

If you currently have a 401(k) loan or are thinking about one – and you think you may leave your job in the foreseeable future – it’s important you know the rules upfront. 

Because you will have to pay off the outstanding balance in a much shorter time frame than originally planned or face penalties and taxes.

The Cost of Leaving a Job with a 401(k) Loan

401(k) loan

It doesn’t matter if you leave voluntarily or you are terminated. You have to pay back the 401(k) loan in full.

Under the Tax Cuts and Jobs Act (TCJA) passed in 2017, 401(k) loan borrowers have until the due date of your tax return to pay it back. Prior to this, loan borrowers had 60 days to pay it back.

This means that, if you lost your job and the distribution of the unpaid loan happened in March of 2021, you’ll have until Monday, April 18, 2022, (when you file your tax return) to fully pay back the loan.

If you don’t pay the full unpaid balance by this date, the loan will be treated as an early withdrawal, and the unpaid loan balance will be considered a taxable distribution

And, if you are under age 59½, you will also have to pay a 10% federal tax penalty on the unpaid balance along with income taxes on the balance of the loan.

Don’t Forget the Opportunity Costs

401(k) loan

As you can see, it can be costly to leave a job before you’ve repaid your 401(k) loan. 

If you don’t have the money to pay back the balance before the next tax filing deadline, you may be forced to incur more debt on credit cards or have to tap into your emergency savings. 

All of which defeats the purpose of why you took out the loan in the first place. 

This is why we advise our clients not to treat a 401(k) like a bank because borrowing now may have serious consequences for your retirement future

With healthcare costs rising and the future of social security uncertain, you need all the retirement savings you can get. 

Many 401(k) plans prohibit making regular contributions until the loan is paid. 

If your plan has this provision, taking a 401(k) loan may significantly impact your future 401(k) balance because you’ll be missing out on compounded earnings. 

If your employer offers company matching, you’ll miss out on those additional funds as well. 

On top of that, there are tax implications. If you aren’t able to contribute, you will not be able to write off the pretax income you would have otherwise put in your 401(k). 

Even if your plan allows you to make regular contributions while repaying the 401(k) loan, you run the risk of not being able to afford contributions while paying it off. 

That’s a lot of missed retirement savings

And, finally, taking out a 401(k) loan can also tie you to a job you dislike should you need to stay with your employer until the loan is repaid in full.

4 Ways to Pay Off a 401(k) Loan Faster

401(k) loan

Ready to quit your job, but have a 401(k) loan and want to avoid penalties and taxes? Here are a few action items you can do today to pay off your loan quickly: 

#1 Round Up Payments 

Every time you make a payment, round up to the nearest hundred (or thousand). If you pay $420 each month, round up your payments to $500. Do this for 12 months, and you’ll have paid an additional $960 – and take off the loan term a little over 2 months. 

#2 Make Extra Payments

The fastest way to bring down the balance and pay your 401(k) loan in full is to make extra payments each month. If you can’t do that, then plan to make larger quarterly payments. 

#3 Use Your Tax Refund

If you’re getting a refund this year, apply the full amount to your 401(k) loan balance. Even if you only get $200 back, the extra payment will make a difference.  

#4 Tap Into Your Savings

This option is not ideal, but if you want to leave your job ASAP (especially for a higher-paying one), it may make sense to do so to avoid penalties and taxes. Just make sure to put the money back as soon as possible.

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Sources: 

  1. https://www.gobankingrates.com/money/economy/the-great-resignation-who-is-quitting-which-jobs-suffering-most/
  2. https://www.protocol.com/bulletins/worker-resignation-2022
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