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If you've taken out loans against your 401(k) retirement funds, you may have to pay off your loan in full when you leave your job—voluntarily or not.
Once you are no longer employed, the reasoning goes, you no longer have a paycheck from which to deduct payments. Your loan could be due and payable in short order, whether or not you have the means to pay it off.
Coming up with cash to pay off a loan may be the last thing on your mind when you're changing jobs or contemplating unemployment. Here's what to know about 401(k) loans when your job is ending.
How Does a 401(k) Loan Work?
A 401(k) loan lets you borrow money from your retirement savings and repay it, with interest, over time. A 401(k) loan typically doesn't require a credit check or credit approval. It's easy to repay using automatic payroll deductions, and interest rates are usually low.
Loan limits and terms can vary from one plan to the next, but as a rule workers can borrow up to $50,000 or 50% of their retirement savings. According to Vanguard's How Americans Save report, about 1 in 8 U.S. workers (12%) has a 401(k) loan.
You normally have five years to pay back a 401(k) loan—sometimes longer if you use the money to buy a primary residence and your plan rules allow for a longer timeframe. But if you quit your job or are terminated, you may be required to repay your 401(k) loan in full.
Do You Have to Pay Off a 401(k) Loan When You Leave Your Job?
Though there are exceptions, many plans require you to pay off your 401(k) loan in full when you leave your job. Check your plan's summary plan description for details on whether and when you are required to pay. You may have a short grace period after your employment ends to come up with the money and avoid consequences.
What if You Can't Repay Your Loan in Full?
If you can't repay your 401(k) loan in full by the plan deadline, your remaining loan balance may be taken out of your 401(k) funds as a "loan offset." Say you have $50,000 in your 401(k) account and a $10,000 401(k) loan. A loan offset eliminates your outstanding loan and reduces your 401(k) account balance to $40,000.
Do You Owe Taxes on a 401(k) Loan You Can't Repay?
A loan offset is a taxable distribution: You'll pay regular income taxes on the loan offset amount, plus an early distribution penalty of 10% if you're under age 55. In some cases, your loan offset amount may be rolled over into your new employer's 401(k) plan (if they accept rollovers) or a rollover IRA to avoid tax consequences. (More on that below.)
Does Defaulting on a 401(k) Loan Hurt Your Credit?
When you take out a 401(k) loan, you're essentially borrowing from yourself. Unlike traditional bank loans, these loans are typically made without a credit check. The debt also isn't reported to credit bureaus, and neither are defaults.
How to Pay Off a 401(k) Loan
The first question to ask is when you need to pay off your 401(k) loan. This typically depends on individual plan rules. If you can pay off your loan in time, you may avoid tax complications and leave your 401(k) balance intact.
If you want to pay back the loan but can't make your plan's payoff deadline, you may have a second chance: rolling your loan offset amount into an eligible retirement plan, typically a 401(k) that accepts rollovers or a rollover IRA. According to rollover IRA rules, you have 60 days to deposit the funds into a new, qualifying account. If your employment was terminated, you have until the tax filing deadline, including extensions, to put loan offset funds into a rollover account to avoid taxes—and recoup your retirement account balance.
Where do you get the money to repay your 401(k) loan?
- Use your available cash or savings. This may be easier said than done if your loan balance is high and your savings are limited. However, if you can swing it, using your liquid assets will save you the cost and effort of borrowing money.
- Look into a new 401(k) loan. With some planning (and favorable plan rules with your new employer), you may be able to take out a new 401(k) loan to pay off your old loan—or replace the funds in a rollover. Alternatively, see if your spouse has access to a 401(k) loan at their place of employment.
- Tap your Roth IRA. Though it's never ideal to take money from retirement savings, contributions to (and not earnings from) a Roth IRA can be withdrawn at any time without penalty. Tread carefully: Once you take the money out of your Roth IRA, you can't pay it back later.
When all else fails, you can always accept the loan offset and prepare for a tax bill. Although the tax hit can be tough—easily topping 30% of your loan balance—you won't have to take money out of savings or apply for a new loan, which can be especially difficult if you've lost your job.
The Bottom Line
Don't be caught off guard. If you've recently lost your job or are contemplating a new position, review your plan documents or ask your plan administrator about loan repayment terms. In fact, even if you aren't planning a job move, you may want to double check the rules so you know what to expect.
If a personal loan or home equity loan is part of your repayment strategy, you may want to check your credit report and credit score first. Knowing where your credit stands can help you find the best loan rates and terms—and possibly the best resolution for your outstanding debt.