How to Avoid Taxes With an Outstanding Loan in Ex-Employer 401(k) Plan

By Joe Cicchinelli, IRA Technical Expert

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Let’s say that your employer’s 401(k) plan allows you to take a loan against part of your 401(k) balance (generally the smaller of half of your vested balance or $50,000). You decided to take a loan and you’ve been repaying it by having it taken out of your paycheck. But now, you no longer work for that employer. Perhaps you retired, or voluntarily switched jobs, or maybe you were laid off. Regardless, when you no longer work for that employer and you have an outstanding loan balance in your 401(k) plan, you’ll have to address some issues to avoid tax consequences.

Now that you don’t work for that employer, you are probably eligible to receive a distribution of your 401(k) balance due to the fact that you separated from service. But, what about your unpaid 401(k) loan? In all likelihood, you’ll be given a 60- or 90-day grace period to pay off the loan balance. During that time, you might, for example, pay off the 401(k) loan by getting a bank loan.

After the grace period, if you haven’t paid the 401(k) plan loan, the plan will do a “loan offset” whereby the unpaid loan balance will be subtracted from your 401(k) balance, but the plan will report the full balance (including the unpaid loan) as being paid out as a taxable distribution. The amount of the unpaid loan is the loan offset amount.

The loan offset amount will be taxed to you and subject to the 10% early distribution penalty if you’re under age 59 ½. However, you can avoid taxes and penalties by rolling over the loan offset amount to your IRA within 60 days. You’ll have to come up with the cash from personal assets or a bank loan, but at least you have an opportunity to avoid taxes on the offset amount.