Taking a loan from your 401k plan can be a major help if you run into unexpected expenses or find yourself in a financial bind. However, after the loan has been made, you may run into some interesting challenges that arise if you decide that you want to perform a 401k rollover. Fortunately, there are few things that you can do to help navigate these rather complex financial waters.
When you take money from your 401k and are still employed by the company with whom you have the 401k plan, you can pay back the loan over time by electing to have a small amount taken out of your paycheck each week. This, of course, is the best way to pay the loan back and maintain the tax-deferred status of your remaining funds. Ideally, by the time you’re ready to leave the job; you’ll have paid back the loan and will be able to do a 401k rollover without any complications.
However, the situation changes dramatically when you change jobs. Under the rules of most 401k accounts, you’ll have a short time – usually only 60 days – to pay back the money that remains outstanding on your loan. Paying back the loan before you attempt the rollover is usually the best option because otherwise, the money you took out will be treated as a distribution, which could open you up to unnecessary taxes and penalties.
If you attempt to initiate the 401k rollover before paying back the entirety of the loan, the money you received as a loan will be subject to taxes. In addition, if you’re under the magic retirement age of 59 ½ years old, you may be required to pay additional early withdrawal penalties. Usually, your loan will be taxed as income, plus 10%. As an example, let’s say that you took out a loan of $4,000 from your 401k account and your current tax bracket is 25%. If you attempt a 401k rollover before the loan is paid off, you’ll pay as much as $1,400 in penalties and taxes!
In most cases, what will likely happen is that the financial institution that made the loan to you would hold about 20% of the amount of your 401k account balance and the remainder you owe would come due at tax time, as the 401k plan distribution will be treated as income on your tax return. Keep in mind that this additional income may push you into a higher tax bracket, causing you to owe even more come April 15th.
Of course, the simplest way to avoid all of this is to pay the 401k loan back before ever attempting a 401k rollover. With the money safely back in the account, all of these consequences are wiped off the board, and you can treat the rollover just as you would any other transfer.
In fact, the complexity of this issue is one reason why some 401k plans don’t allow loans to their participants. Some larger businesses enjoy offering this service to their employees, but it’s clear that the headaches that come when an employee takes money from the 401k and then the leaves the business aren’t worth it in most cases.