By Justin Fundalinski, MBA | November 20, 2017
Considering many people’s 401(k)s are usually one of their largest retirement savings assets and many 401(k) providers offer the ability to borrow money, it can be very enticing to take out a loan from your 401(k) to help fund your next big purchase. 401(k) loans are quick, easy, and do not need a credit check. Unfortunately, there are some downsides to borrowing money from a 401(k) and understanding certain issues can help you make the right lending decisions as well as potentially avoid steep tax consequences. Particularly in this article I will focus on what happens when a 401(k) loan defaults and what options you have.
401(k) loan basics:
While this article is not focused on all the details of a 401(k) loan it is important to know a few basics prior to digging into the main topic of this article.
- Most plans allow for loans of 50% of your 401(k) balance with a maximum loan of $50,000. That is, if you have a 401(k) valued at $80,000 the maximum you could borrow up to $40,000, while if your 401(k) is valued at and amount greater than $100,000 you could borrow a maximum of $50,000.
- You must amortize the loans over a five year period and make regular payments (usually through payroll deductions). The IRS defines timely payments as level amortized payments at least quarterly. Prepaying the loan is completely acceptable and there are no prepayment penalties.
- If you cannot pay the loan back (the loan defaults), then the unpaid amount is considered to be a taxable distribution and you could face a 10% penalty if you are under the age of 59½.
How can a 401(k) loan default?
Because most loan payments are generally required to be paid back with deductions from your paycheck the default rate on 401(k) loans is relatively low. However, the single biggest cause of loan defaults is the loss of one’s job. Once separated from employment (whether voluntary or involuntary), your employer can no longer just debit your paycheck to ensure timely payments and the full balance of the loan must be repaid promptly (usually within 60 days) to avoid the loan going into default.
Less commonly, loan payments are not required to be paid back via deductions from your paycheck and you become fully responsible for ensuring timely payments. Of course, laying the responsibility of making timely payments on the loan recipient opens up the door to loan defaults. Falling behind on payments can cause a loan to default.
What happens when the loan defaults?
When default is on the horizon you essentially have two options to avoid it. You can pay back all remaining principal on the loan (or catch up on your timely payments if you are not separated from your job) to avoid it being considered a default, or you can let it default and deal with the consequences.
The consequences can be relatively steep. While this type of “default” will not be reported to the credit bureaus causing your credit rating to be damaged, the IRS plays its hand and collects the taxes and penalty due.
The remaining balance that is left unpaid is considered a distribution from your 401(k). Income taxes will be due on this distribution at your highest marginal tax bracket(s). This “distribution” has a double negative effect. First you will have to pay taxes on what is considered to be a lump sum of income. If this occurs in a year of high earnings you could see a substantial tax hit on funds that otherwise may have been removed a lower tax rates. Second, you have removed a sizable chunk of money from tax deferred retirement savings and will never be able to get this money back into its preferred tax deferred status.
Additionally, there could be an early withdrawal penalty tax. As you may already know, early withdrawals from your 401(k) plan are generally subject to a 10% Federal tax penalty if taken prior to age 59 1/2. However, if you left your employer in or after the year in which you turned 55, you may not be subject to the 10% early withdrawal penalty, so the age limit on this early withdrawal penalty on defaulted loans is often bumped down to age 55..
Are there any loop holes to avoiding default?
Depending on how someone defaults there are few opportunities to avoid steeper taxes and penalties.
If you are separated from your job:
- There it not much wiggle room in this scenario. However, if you are retiring and in control of when you technically separate from your job it would be a good idea to allow the loan to default in a year when you will not have a lot of taxable income. So, in a best case scenario you would retire at the beginning of the year, allow the loan to default, not earn a lot wages for the remainder of the year, and cause the “distribution” from your 401(k) to be taxed at lower marginal rates.
If you are not separated from your job:
- There is a whole lot of opportunity in this case. The IRS has permitted for retirement plan administrators to allow for what is called a cure period. A cure period is essentially a grace period on your loan payment and can last no later than the last day of the calendar quarter following the calendar quarter in which the required installment payment was due.
- If your employer allows for a cure period (it is their option) there are two ways to get back on track and avoid default:
- You can pay back all missed payments during the cure period and avoid the loan going into default.
- You can refinance the loan (pay off the loan and the missed payments with a new loan) and essentially re-amortize your payment over a new five year period.
Loss of a job can come at any time. One may separate from a job due to cut backs, under performance, promotion opportunity at another company, or simply because it is time to retire. Because separation from a job requires prompt payment of the outstanding loan balance, this life event may cause a burdensome taxable event.