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By Jenn Pavlick
November 9, 2023
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Taking a loan from your 401(k) plan is usually seen as a last resort, but it might be the case that you want to roll over your 401(k) that has a loan on it already. If this is you, there’s no need to worry, but you’ll want to be aware of the details when it comes to rolling over your qualified retirement plan.
Here, we’ll review the considerations around rolling over your 401(k) plan if you’ve got an outstanding loan.
The reality is that you’ll most likely need to settle your 401(k) loan before rolling over your account balance to a new provider. Some administrators may allow you to roll over your “net” 401(k) balance (total balance less your current loan balance), but you’ll still need to keep making payments on your original loan.
This is not to say it’s inconceivable that another provider would accept a 401(k) plan with an outstanding loan balance, but it’s not likely to be the outcome in the grand majority of cases.
Similar to the above, it’s recommended that you settle your outstanding balance with your original 401(k) plan administrator before rolling over your account to an IRA – especially since IRAs don’t support loans.
You can, however, roll over the net balance (total balance less the current loan balance) to an IRA and keep making payments on the initial loan. If you fail to make loan payments after you’ve rolled over your net 401(k) balance, the loan will be considered “in default”, and you’ll be liable for income taxes and early withdrawal penalties.
If you do find yourself in default, but you still want to roll over your 401(k), the plan may “offset” the loan amount by reducing your 401(k) plan balance by a lump sum. The offset is considered taxable income, and if you’re below age 59.5, you’ll also be hit with an early withdrawal penalty (10% of the offset).
When it comes to the infamous 401(k) “offset”, you can avoid taxes by rolling over the cash equivalent of the offset amount (or the unpaid loan balance) to the IRA receiving the rollover. In effect, this is like paying back your pre-tax IRA rather than the 401(k) plan.
Needless to say, this can get complicated – and fast. Be sure that you’ve read your 401(k) summary plan document so that you’re sure of any unique provisions, ideally before taking out any loans in the first place.
If you switch to a new employer and your old employer plan has a loan balance, you’ll still be required to make payments on your loan. If you don’t make installment loan payments — or otherwise find yourself in default on the loan — you’ll have income tax consequences to consider.
Right away, nothing. But you’re required to continue making payments on your 401(k) loan even if you leave your job.
You’ll need to pay off your outstanding loan by the Federal tax return due date, which falls in mid-April of the year after you quit.
Since this isn’t any fault of your own, you should be eligible to transfer your 401(k) balance to a new 401(k) plan or to a Solo 401(k) of your choosing. In these cases, your 401(k) loan balance would transfer along with the assets.
If you were to transfer assets to an IRA, you’d need to settle the loan balance one way or another because IRAs do not support loans.
A “deemed distribution” occurs when your retirement account loan goes into default. This can happen if you don’t make payments, or you’ve otherwise violated the terms of the loan.
If your loan has been deemed an actual distribution, you’ll owe income tax and an early withdrawal penalty (10%) on the entire amount borrowed – and you’ll still have to make payments towards the loan.
You’ll receive a 1099-R for the deemed distribution at tax time, and the loan deemed distributed cannot be rolled over to another provider. The 1099-R is, in effect, evidence that the distribution has been reported to the IRS, and you’ll need to report it on your tax return.
On the other side, a “loan offset” is a reduction in your retirement plan assets by the amount of the unpaid loan balance. This most frequently happens when you leave your former employer and you have an outstanding loan against your 401(k).
Unlike a deemed distribution, a loan offset can be rolled over to an eligible retirement plan, like another 401(k), a traditional IRA, or a Roth IRA. If you successfully roll over the loan offset amount by the tax filing deadline for the year in question, you can avoid income taxes and the early withdrawal penalty.
The new extended deadline comes as a result of the Tax Cuts and Jobs Act of 2017. The repayment period used to be even shorter.
A 401(k) offset is taxed at ordinary income rates (your highest rate), and you’ll also owe a 10% early distribution penalty if the plan loan offset happens before you’ve attained retirement age of 59.5. In other words, your loan turns into a taxable distribution.
As described above, this can be avoided by rolling over an amount equivalent to the offset before the tax filing deadline for the year in question.
Repayment is critical. If you don’t pay back the amount of the loan directly, you’ll be compelled to pay it another way. The loan will either be deemed a distribution, or you’ll see a plan loan offset reduce your 401(k) balance. Failing to pay back a 401(k) loan can be costly both in terms of dollars lost today and the opportunity cost of lost retirement savings.
Failing to pay back your 401(k) loan can also hurt your credit score.
The best place to look is your 401(k) plan’s related legal document – sometimes called a “summary plan document” – which should clearly stipulate all loan provisions. You also have the option to consult with a financial advisor to assist in making sense of your 401(k) plan loan.
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