Tax reform gives some 401(k) borrowers more time to repay

Young African-American couple reviewing their finances and considering how they'll budget to repay their 401(k) loans since tax reform gave borrowers more time. Young African-American couple reviewing their finances and considering how they'll budget to repay their 401(k) loans since tax reform gave borrowers more time. Image:

In a Nutshell

Before tax reform, if you left a job with an outstanding balance on a 401(k) loan, you typically had just 60 days to repay the loan in full or roll it over into another eligible retirement plan. Failing to take either action meant facing taxes and penalties on the outstanding balance. But tax reform has stretched the repayment window. Here’s how it works.

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A 401(k) loan can be a convenient, low-interest way to get money when you need it.

But borrowing from your 401(k) comes with some disadvantages. When you take money out of your retirement plan, those borrowed funds are no longer growing. Plus you have to repay the money to your retirement savings, even though you technically borrowed it from yourself.

And while you’d normally have years in which to repay the loan, if you leave your job before you’re done repaying, the balance becomes due or risks being treated like a taxable distribution (known as a “loan offset”). You typically had 60 days in which to repay or roll over the balance into another eligible retirement plan. Missing that small window meant the loan offset was reported to the IRS as taxable income, and subject to a 10% early-withdrawal penalty.

However, the Tax Cuts and Jobs Act of 2017 has given 401(k) borrowers more time to repay or roll over outstanding 401(k) loans after leaving a job. Still, that doesn’t mean these loans are risk-free. Let’s look at how 401(k) loans work and how tax reform affected repayment terms.


401(k) loan basics

Your 401(k) is meant to help you save for retirement, and the money you defer from your paycheck into your 401(k) isn’t included in your taxable income. But when you take money out of your 401(k), that withdrawal generally is taxed at whatever your tax rate is at the time of the withdrawal. And if you take money out of your 401(k) before you’re age 59½, you could also be hit with a 10% penalty for making an early withdrawal, on top of regular taxes you’ll owe on that money.

If offered by your plan, a 401(k) loan allows you to borrow some of the money in your account without it being considered a taxable distribution. So as long as you repay the loan according to the terms of your loan agreement, you should be able to avoid paying taxes and penalties on the withdrawal.

According to IRS regulations, 401(k) loans must be repaid in “substantially equal payments that include principal and interest and are paid at least quarterly.” You must repay the loan (typically through payroll deductions) within five years, unless you’re using it to buy your primary residence, in which case the term can be longer.

And as with most loans, you’ll pay interest on the amount borrowed. But it isn’t paid to a lender. Since you’re borrowing your own money, the interest instead goes back into your own retirement account.

Leaving your job when you have a 401(k) loan

When you take a 401(k) loan, there’s always the chance you’ll leave your job (voluntarily or otherwise) before you’ve finished repaying the loan.

Prior to recent tax reforms, an employee who left a job (or who was laid off or fired) typically had 60 days to repay or roll over an outstanding balance into another eligible retirement account before it would be treated as a taxable distribution.

The Tax Cuts and Jobs Act significantly extended the window to repay or roll over an outstanding balance on a 401(k) loan when a borrower leaves an employer. Effective for tax years beginning in 2018, the deadline is now the due date of the employee’s tax return for the year in which the distribution occurs, including extensions.

This means if you leave your job during 2018, you would have until April 15, 2019, to repay, or Oct. 15, 2019, if you get an extension.

FAST FACTS

How to request an extension for your federal income tax return

You can request a six-month extension of your federal income tax return by filing Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return. Keep in mind that this is only an extension of time to file your return, not an extension of time to pay any tax due. You are required to estimate the amount due and pay by April 15 even if extending your filing deadline. Otherwise, you may be charged interest and penalties. Learn more about how to file a tax extension.

What happens if you don’t repay your 401(k) loan?

If you don’t make payments according to the terms outlined by your plan — whether you’re still with your employer or not — your loan is in default and the outstanding balance of the loan is treated as a taxable distribution from the plan. Your employer will then report the distribution to the IRS on Form 1099-R.

When you file your tax return for that year, you’ll be required to include the distribution amount in your taxable income. If you’re younger than 59½ and need to calculate a penalty for early withdrawal, report it on Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.

There are a few circumstances other than the age limit in which you can avoid that 10% early-withdrawal penalty. Those exceptions are listed in detail in the Form 5329 Instructions. Some common ones include …

  • Disability
  • Unreimbursed medical costs exceeding 7.5% of your adjusted gross income
  • Distributions used to pay health insurance premiums for unemployed individuals
  • Distributions used to pay higher education expenses

Good news for 401(k) borrowers

“All in all, this is a good rule change, because many people leave jobs involuntarily,” say Dr. Ronald Stair, principal and chief actuary at Creative Plan Designs Ltd. in East Meadow, N.Y. “People would find themselves unemployed and suddenly need to repay their 401(k) loan. But consider how much time it actually gives you. If you leave your job in December and have to repay your loan by April 15, you gained some leverage, but not much. However, if you leave your job early in the year, you may have 12 months or more to repay the loan.”

Another bit of good news: If you can’t afford to repay your 401(k) loan after leaving your employer, the default won’t impact your credit scores, because employers don’t report 401(k) loan defaults to the credit bureaus.

How can you repay a 401(k) loan and avoid default?

Now that you’ve got more time to come up with a strategy to repay your 401(k) loan and avoid the tax impact of a default (thanks to 2017’s Tax Cuts and Jobs Act), what are some options for repayment?

Dr. Stair recommends first looking at whether you have savings somewhere else that can be used to repay the loan.

“Of course, if you’re borrowing from your 401(k), you may not have other savings,” he says.

If you don’t have other easy-to-access savings, you might consider one of these options.

  • Tapping your home equity. A cash-out refinance, home equity loan or home equity line of credit can tap the equity in your home to repay a 401(k) loan. The HEL or HELOC is in addition to your existing mortgage, whereas a cash-out refinance replaces your current mortgage with a new, larger loan. Keep in mind, though, you could wind up with a higher interest rate and pay thousands of dollars in closing costs with these options. And if you can’t repay your 401(k) loan because you lost your job, you may also have trouble getting approved for a loan.
  • Using a credit card. You may be able to pay off your 401(k) loan with a credit card, but this is a risky strategy. The interest rate on a credit card is likely to be much higher than you were paying on the 401(k) loan, and you’ll also have to keep making payments on the credit card. Before deciding on this strategy, compare the cost of using a credit card to pay the balance with paying the additional tax and penalties you’d owe.
  • Selling other assets. Now might be a good time to consider selling other assets to come up with enough money to repay your 401(k) loan. Selling your car, furniture, electronics, jewelry or other personal items might net enough proceeds to pay off the loan and avoid the tax hit of default.
  • Making wise use of the extra time. Since tax reform gave you extra time to repay your loan, use it to create a repayment budget and schedule. Figure out how much time you have based on the new deadlines. Then divide the total amount you owe by the number of months until your repayment deadline to arrive at a monthly payment. If you already have another job, consider directly depositing a portion of your paycheck into an interest-bearing account so that you’ll have the full amount you need by the deadline.

Bottom line

Borrowing from your 401(k) to buy a home, pay off other high-interest debt or cover other expenses got a little less risky thanks to the Tax Cuts and Jobs Act of 2017, but it’s still not a risk-free (or necessarily the best) option when you need extra cash.

You’ll miss out on the potential compounded earnings on the money while it’s not invested in your account, and many plans don’t allow participants to contribute to the plan while they have an outstanding loan. By borrowing from your retirement, you could be putting your future financial stability in jeopardy, as well as running the risk that you’ll have to repay the loan sooner than planned (or face the tax consequences) if you leave your job for any reason.

In short, the extended time frame provided by the new tax law may prove helpful for borrowers who lose their jobs while they have an outstanding 401(k) loan. But it’s always important to understand the potential pitfalls of borrowing and avoid surprises at tax time.