401(k) Plan Loans: What Are Employees’ Options When They Depart?

Employees who have outstanding 401(k) plan loans when they leave their job are sometimes faced with the difficult quandary of needing to repay the loan in full within 60 days of termination of employment. If the loan isn’t repaid within this time, employees are generally assessed a 10% penalty on the outstanding loan amount. In addition to the penalty, they are taxed at ordinary income tax rates on the amount, which is considered a “deemed distribution.”

A deemed distribution is different from other disruptions in that the participant is taxed as if the distribution was received, but the treatment of the loan as a distribution does not excuse the participant from the obligation to repay the loan.

A Popular Option

Borrowing money from a 401(k) plan has become increasingly popular among employees in recent years. According to the Employee Benefits Research Institute (EBRI), one out of five employees who are eligible for a 401(k) loan has taken one out — whether to help cover financial emergencies, finance home improvement projects or pay for other expenses.

In the hustle and bustle that sometimes accompany a job change, though, employees sometimes don’t realize the need to repay their 401(k) loan in full soon after they leave their job. When this happens, employees may get an unpleasant surprise when they receive a Form 1099-R from the IRS, informing them that they underreported income and owe additional taxes and penalties.

Even if employees are aware of their 401(k) loan repayment responsibilities, it may be difficult for them to make repayment in full in such a short time period. This is especially true if the employee was laid off or let go involuntarily and is facing an uncertain employment future.

If they can’t access enough liquid cash to repay their outstanding 401(k) loans in full, employees generally have two choices: they can either pay the 10% penalty and income tax when they file their tax return or borrow money from another source to repay the loan.

For example, they could possibly tap a home equity line of credit, obtain an unsecured credit line or take advantage of a zero percent credit card balance transfer option. These alternatives are often preferable to the financial consequences of having an outstanding loan classified as a deemed distribution.

Help Your Employees

So what can you do to help your employees — both those departing and new employees joining your company — who are facing this potential dilemma?

The first step is to establish clear communication channels to inform participants about the need to repay their 401(k) loan soon after they leave your employment. Make this a part of your standard communication protocol for all departing employees.

Some plan sponsors allow employees to continue making 401(k) loan payments after they have left the company. Check to see if your plan documents allow this — if they don’t, consider whether amending the documents makes sense.

Keep in mind that payroll deductions of loan repayments would no longer be possible after employees have left your company, which could make this option challenging from an administrative standpoint. And if a former employee fails to make loan repayments on time and in equal installments, the outstanding loan amount will be considered a deemed distribution, and the 10% penalty and income tax will be assessed.

You might also consider allowing new employees joining your company to roll over outstanding 401(k) loans into your company’s plan and continue making loan payments. But this wouldn’t be an option if new employees aren’t eligible to participate in your 401(k) plan within their first 60 days of employment.

Again, you’ll need to see if your plan documents allow this and decide whether to amend them if they don’t.

Plan Ahead Now

Given the popularity of 401(k) loans, it’s smart to plan for how you can help employees who leave or join your company and have outstanding loans.

Contact your BMF Advisor to assist in planning strategies that can help you effectively administer your plan.