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

Employee Benefit Plan Audit | August 8, 2018 | Holtzman Partners

Employees who have outstanding 401(k) plan loans when they leave their job are sometimes faced with a difficult quandary. This is because the loan generally must be repaid in full within 60 days of the termination of employment.

If the loan isn’t repaid within this time, employees are generally hit with a 10 percent penalty on the outstanding loan amount. In addition, they have to pay taxes at ordinary income tax rates on the amount, which is considered to be a deemed distribution.

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 so short a time. 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 percent penalty and income taxes 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 percent tax penalty and income taxes will be assessed.

Note that a 401(k) plan loan in default is considered to be a plan asset, so interest continues to accrue even if it’s treated as a deemed distribution. The accrued interest, however, is not included in the plan participant’s income.

Similarly, 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. If you do decide to offer this option, it could be a nice enticement for potential employees who are thinking about joining your company.

Plan Ahead Now

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

Our Employee Benefit Plan team can assist you in planning strategies that can help you help your employees. Give us a call at 512.610.7200 to discuss your situation further.

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