By Gary Alt
Learn more about Gary on NerdWallet’s Ask an Advisor
Great question. The answer is somewhat complex and the penalty for making a mistake is very costly, so you’ll want to make sure you pay off the loan properly.
When you leave the company, regardless of whether you were fired or resigned, you must pay off your 401(k) loan within a certain time period. If you don’t, the remaining balance is automatically considered a taxable distribution. What that means is that the following April, you’ll owe federal and state income taxes on your loan at a higher ordinary income tax rate – not the lower long-term capital gains rate.
If you’re under 59½ years old, you’ll also pay a 10% penalty. Even after you’ve shelled out the money for taxes and penalties, you’ll still need to come up with the money to pay off the original loan. So it’s much less painful to spend some time upfront figuring out how to pay off the loan on time.
The U.S. Treasury allows employers to set the maximum deadline as the last day of the calendar quarter after the quarter in which your most recent loan payment was due. For example, if you leave the company in February 2015 (the first calendar quarter), you’ll have until June 30, 2015 (the last day of the following quarter) to pay off the loan. But employers can set a shorter period if they wish.
So how do you determine your employer’s payoff deadline?
A typical payoff period is 60 days from the date of your resignation. But each plan is different, so you’ll want to find out from your employer. Imagine if you scrambled to pay the loan on the 59th day after you resigned, but the plan’s actual deadline was 30 days after resignation. Or think if the deadline were actually 90 days after your resignation; a hasty decision could cost you even more money. So it’s worth taking time to find the correct answer.
Here’s what you can do:
1. Read your plan documents. Employers have some flexibility to determine the payoff deadline, but the one outlined in the plan is what prevails in each case. The documents might be accessible on the website where you log in to view your 401(k) account, or you may have received it when you originally signed up to participate. Look at the Summary Plan Description (SPD) first, because it’s the easiest to read. If the answer isn’t there, look at any other documents available, searching on the word “loan.”
2. If you can’t find the answer in documents, ask your employer – usually someone in the human resources or finance departments will have the answer. If they don’t, they can ask their plan administrator, which is the company that completes their annual regulatory filings.
3. Get an answer in writing from your employer. The penalty for making a mistake is too high, so you don’t want an off-the-cuff response.
I know, it sounds complicated – and it is. But find out in writing what your company’s policy is, and you’ll avoid a costly mistake.