Leaving Your Job With a 401(k) Loan? Avoid Tax Penalties With a Personal Loan

According to the Employee Benefits Research Institute, about one-fifth of eligible employees with 401(k) plans borrow against them. But leaving your job with a 401(k) loan could be disastrous. You might find yourself owing as much as 50% of that loan amount in taxes and penalties.

This can happen if you have an unpaid balance and:

  • You leave for a job with another employer
  • Your company goes out of business
  • Your company lays you off or fires you

Any of these events can trigger a hefty tax bill for you, even if you’re not at fault. But this is almost certainly avoidable. One alternative is paying off your 401(k) loan with a personal loan.

See personal loan interest rates and programs here

401(k) loan repayment period

When you part ways with your employer, you can avoid paying penalties on your 401(k) loan and having it taxed as income. But only if you repay the loan before the due date for next year’s tax return (including extensions). So if you quit your job in 2019, you should have until October 15, 2020, if you get an extension, to pay off your 401(k) loan.

Failure to repay your 401(k) loan on time

If you miss your repayment deadline, your employer must file a Form 1099-R with the IRS. That means your remaining loan balance is considered income to you and taxed at your ordinary income tax rate. In addition, you will likely have to pay a penalty of 10% of the balance.

You can see how this could add up. Suppose that you owe a balance of $10,000 against your 401(k) when you leave your employer. If your federal tax bracket is 32%, your state income tax bracket is 5% and you have to pay a 10% penalty, that’s 47% altogether. Instead of $10,000, you owe $14,700!

But wait; there’s more. The IRS charges interest on that amount until the day you completely clear that debt. Currently, that’s 0.5 percent per month. So, assuming that it takes you five years to zero out your IRS debt, your payment would be about $284 per month. And your total cost of borrowing that $10,000 balloons to over $17,000.

Related: What Is a Personal Loan, Unsecured Loan or Signature Loan?

Pay 401(k) loan with a personal loan

If you take a proactive approach and repay your 401(k) loan with a personal loan, you’ll almost certainly pay less. For one thing, your loan won’t be considered income, and you avoid income tax and the prepayment penalty. As of this writing, the average personal loan interest rate is just under 11%.

If you pay $284 per month with a personal loan at 11%, you can clear your $10,000 balance in about 3.5 years and save nearly $5,000 (in this example — everyone’s circumstances are different). That’s much better than ignoring your problem and letting the IRS make choices for you.

Of course, to make an informed decision, you must compare actual loan offers and costs from personal loan providers. Your rate depends on your credit rating, income, loan amount and the length of your personal loan term.

Related: Personal Loan Interest Rates (How to Pay Less)

Exception to 10% penalty on unpaid 401(k) loan

Not everyone who leaves a job with a 401(k) loan has to pay a 10% penalty. If you retire (as opposed to changing employers) or are let go by your company and you are 55 or older, your unpaid loan won’t be penalized. However, the government still considers that amount taxable income to you.

Repay a 401(k) loan: running the numbers

Even if your remaining 401(k) loan balance is not penalized, you might want to pay off the loan anyway. Because 401(k) distributions are still taxable income. Your tax bracket and credit rating are important in determining if you should take a loan to repay your 401(k) or just pay the tax.

If your bracket is 15% and the best personal loan rate you can get is 36%, it might not make sense to pay off your 401(k) loan with another loan — just pay your taxes due.

If you can get a personal loan at a rate that’s lower than your income tax bracket, run the numbers before writing that painful check to the IRS.

Compare personal loan interest rates and terms here