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The price of paying back my 401(k)
I borrowed against my 401(k) and am paying it back. But what happens when I leave my current job?
July 29, 2002: 11:09 AM EDT
By Walter Updegrave, CNN/Money Contributing Columnist

NEW YORK (CNN/Money) - I've borrowed against my 401(k) and am currently paying it back. I plan on changing jobs soon, however, and I'm wondering what will happen to my 401(k) loan when I leave my current job? Could I be penalized somehow?

-- R. Leinbach, Sahuarita, Arizona

I congratulate you for thinking about this issue before you make your job switch. Fact is, there are some potentially sticky issues here and you could end up being hit by taxes and penalties if you don't handle things right.

When someone takes out a loan against his or her 401(k), the employer usually automatically deducts the loan payments from the paycheck. This makes it easy for the employee to repay the loan. And it also makes it easier for the employer to keep track of whether the loan is being repaid or not. That's important because if the loan isn't being repaid, then the loan can be characterized as a distribution from the 401(k), which means it would likely become taxable and also probably subject to a 10 percent early withdrawal penalty.

So what happens to an outstanding loan if you leave -- or, for that matter, are fired -- from your job? That depends on how your employer has set up your plan. Some companies may be willing to let you continue making payments on your loan.

This usually isn't the case, however, because it becomes a bit of an administrative headache for the employer. After all, since you're no longer on the company's payroll, there's no way they can automatically deduct loan payments from your check. That means the employer would have to set up some other system of receiving the payments and crediting them to your 401(k) account, a process most employers simply aren't equipped to handle and, understandably, probably don't want to incur the expense to set up.

As a result, most employers simply require that you repay any remaining loan balance in full before you leave. Fail to do that, and the outstanding balance will be considered a distribution subject to income tax and, possibly, a 10 percent penalty.

Start with your HR department

So the first thing I suggest you do is contact your human resources department or whichever entity handles your 401(k) plan and find out what the rules are concerning 401(k) loans when an employee leaves the company. (Assuming you don't want to come right out and say you're planning on leaving, you can probably go about this discreetly by saying you just want to clarify all the rules concerning 401(k) loans.)

If it turns out your employer does require immediate repayment of the loan when you leave, you have a few options. One is to increase the payments so you'll have paid off the loan by the time you jump ship. Another is to line up some type of loan -- perhaps a home equity line, a loan against securities you own, even an unsecured personal loan -- that you can draw on to provide the funds to repay your 401(k) when you're ready to leave. Depending on its rate, you could then simply continue repaying this loan.

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Or, if you roll over your old 401(k) balance to the 401(k) plan of your new employer, you could repay the loan from proceeds you get from borrowing against your new 401(k) account, assuming, of course, your new employer allows loans and you're eligible to borrow under the terms of the plan. You could then begin repaying the loan via payroll deductions at your new company.

Whatever you do, however, you want to do all you can to avoid having to pay taxes and a penalty on that outstanding loan balance. Granted, tax rates have come down a bit the past two years. But any money you shell out for taxes and penalties now means you'll have that much less at work in your 401(k).

Walter Updegrave is the author of Investing for the Financially Challenged and can be seen regularly Monday mornings at 8:40 am on CNNfn.  Top of page

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