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Are you quitting your job? Here’s what will happen to that 401(k) loan you have

By on June 7, 2022 0

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If you’re headed to a new job and still owe money on a 401(k) loan from your former employer’s retirement savings plan, make sure you know what will happen to that. outstanding balance.

Although you may be allowed to continue repaying the loan in installments, most companies expect immediate repayment when you leave. And if you don’t pay what’s owed, it can lead to an unexpected tax bill.

“Generally, if you have a loan and you quit your job, you’re supposed to pay off the loan in a short period of time,” said certified financial planner Avani Ramnani, managing director of Francis Financial in New York. “If you don’t, it’s considered a taxable distribution. [consequences].”

Last year, about 13% of 401(k) participants had an outstanding loan, according to Vanguard’s How America Saves 2022 report, released Tuesday. Although largely unchanged from 2020, the share is down from 16% in 2016.

The average balance on these loans is $10,614 and is more common among workers with incomes between $30,000 and $100,000. About 81% of plans allow loans, with repayment terms typically of five years.

Additionally, use of 401(k) loans is highest among participants ages 45 to 54, at 18%, according to Vanguard’s report. This is followed by 15% in the 35 to 44 year old cohort and 13% among the 55 to 64 year olds.

Federal law allows workers to borrow up to 50% of their account balance, with a maximum of $50,000. The loan is tax-free and, unlike most direct distributions, there is no 10% early withdrawal penalty if you are under age 59.5.

However, when you leave your job, whether by choice or not, the tax treatment may change.

As mentioned, if your plan requires you to repay the money immediately and you fail to do so, your account balance will be reduced by the amount owed. This so-called “loan compensation” is considered a distribution subject to ordinary income tax and potentially the 10% early withdrawal penalty.

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Still, if you can find what you owe, you can essentially defer the loan offset amount to an Individual Retirement Account or other eligible plan and avoid the tax consequences.

You have until the federal tax deadline the following year to do so – i.e. if you leave your job in June 2022, you will generally have until April 18, 2023 to find the working capital (although if you file a tax extension you would get more time).

Prior to major tax law changes that took effect in 2018, participants only had 60 days.