How To Avoid Penalties On Unpaid 401(k) Loans

One of the biggest risks to borrowing from your retirement through a 401(k) loan is the heightened likelihood of the loan becoming a taxable distribution if you leave your job (voluntarily or not) while still paying back a 401(k) loan. Because 401(k) loans are paid back via payroll deduction, when your paycheck goes away, so does the ability to repay it, so many employers require payment in full within 60 days of leaving.

New tax law provides relief

While some employers do allow you to continue to make loan payments if you leave your job, one provision of the new tax law that hasn’t gotten much attention can make a huge difference to people who find themselves in a bind with an outstanding loan and no more job. Basically if you “default” on your 401(k) loan, there is a way to still repay it, but the details matter.

What’s the big deal? 

Prior to January 1, 2018, employees generally had two options to prevent the loan balance from becoming a taxable distribution if they left their employer with an outstanding loan: 

  1. Pay the loan back in full. It is rare that an employee is able or willing to go this route. 
  2. Repay the loan balance via “rollover” by contributing the amount still owed to an IRA within 60 days of leaving your job.  

If you don’t pay back the loan, then any balance from a pre-tax 401(k) becomes taxable income, and if you are younger than 59 ½, you will also owe a 10% penalty for taking an early distribution from your retirement account. Since one of the advantages of taking a 401(k) loan is that it is not taxable if repaid, this can be a hard pill to swallow. 

What’s changed? 

The new law, which applies to distributions treated as being made after December 31, 2017, extends the rollover deadline from 60 days to the tax filing due date (including extensions) for the year in which the loan was considered defaulted. Let’s look at a couple of examples of how this works: 

  • Example 1: You leave your job in January of 2018. You could feasibly have 20½ months to pay back the balance of your loan by depositing the amount owed into a rollover IRA. Why so long? Because you have until the filing due date of your 2018 tax return, which can be extended all the way until October, 2019. If you file in April, the payments would be due by then, so this would be a reason to extend your return (keep in mind this does NOT extend time to pay any taxes due, including if you end up NOT completing the rollover).
  • Example 2: You leave your job in December of 2018. You still have 10½ months (until October of 2019) to pay back the loan via contributions to your rollover IRA, but you may have to stretch a bit more financially to make it happen.

Keep in mind that even if you can’t pay it all back by the deadline, you should still pay back as much as you can to avoid those taxes and penalties.

The logistics 

It’s important to note that you’ll have some paperwork to do in order for this to work. Here’s what I mean:

Let’s say you leave your job in June, while still owing $2,000 on a 401(k) loan. If you extend your tax return for that year until October, you’d have about 16 months to pay back your loan; that’s $125 per month. 

  • Because your old job has no way to know you are paying the loan back into your rollover IRA, they will issue a 1099-R for the $2,000, showing it as a distribution to you.
  • The company where you have your rollover IRA will then also send you a Form 5498 showing you made $2,000 in rollover contributions to the account (make sure the deposits are recorded as a rollover and not new contributions). 
  • If your plan is to pay the loan back via monthly deposits to your rollover IRA, it’s best to check with the IRA company first to make sure they are equipped to handle that while treating each payment as a rollover — it could be a real hassle if they code monthly deposits as new contributions, which WON’T satisfy the loan rollover rule. You may have to set up a separate savings account to collect your monthly payments, then make one lump sum rollover contribution to satisfy the loan rules.

Because it is unclear what type of documentation the IRS will require, make sure to keep all forms and communication you receive and consult your tax professional to help you reflect this process on your tax return. Keep in mind that this process could take a few back-and-forth letters with the IRS, due to the timing of when the 1099-R and Form 5498 are mailed.

To avoid any issues, if you know you are planning on leaving your job, your best bet is to not take a 401(k) loan at all. However, if you find yourself unexpectedly moving on from your current job and have an outstanding 401(k) loan, keep these new rules in mind. Your future self will thank you when it comes time to retire and your present self will thank you for saving a lot of money on taxes and penalties! 

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