Scary Financial Mistakes: Defaulting on a Retirement Plan Loan

Oct 9, 2019

By Edward “Ed” V. O’Neal, Vice President and Manager, Retirement Plans

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Sometimes just the surprises and uncertainty in our daily lives can be scary!   At times, things just don’t work out as planned and events can happen that we didn’t anticipate; like a job change or health issue.  And typically, these situations seem to happen at the worst possible time and can lead to some unplanned and frightening financial challenges.   One such challenge could be defaulting on loans, particularly loans taken from an employee’s own retirement plan.

Loan provisions in employer retirement plans (like a 401(k) plan) have become relatively commonplace, and it can be enticing to some employees to utilize a plan loan to finance big purchases.  Retirement plan loans are generally quick and easy to implement, with no credit check required.  You can borrow up to $50,000 or 50% of your vested account balance.  Loan payments must be made at least quarterly, but most commonly are deducted from employee paychecks.  Plan loans allow you to borrow from your retirement plan balance and pay yourself back with interest.

Although defaulting on a retirement plan loan is relatively infrequent, the single biggest cause of a retirement plan loan default is employee job loss.  Once there has been a separation from employment, either voluntarily or involuntarily, ongoing loan repayments typically can no longer continue (particularly if done through payroll deductions) and the full remaining balance of the loan must then be repaid to avoid a default.  If there isn’t access to funds to repay the entire remaining loan balance, the tax consequences for defaulting can be downright hair-raising, with the outstanding loan balance considered a distribution from the retirement plan and taxable as ordinary income.  Additionally, if under the age of 55, a 10% early withdrawal tax penalty could also be levied.  And in the case of a layoff or involuntary termination, this could result in a tax bill at the least opportune time.

A recent tax rule has provided some relief for anyone caught in this situation by providing an extended time period to repay an outstanding loan balance before taxes and penalties become due.  You now have until your tax filing due date for the year, including extensions, which could be as late as October 15th of the year following termination of employment. The additional time may provide opportunity for someone to recover financially from a job loss, repay the outstanding loan balance and avoid the taxes and penalties from a defaulted loan.

Ultimately, there is nothing inherently bad or scary about retirement plan loans.  But it certainly isn’t a decision to be taken lightly, and like most important financial decisions, there should be careful consideration of key issues, including how the loan repayment will be structured (i.e. payroll deduction, etc.) and the impact or likelihood of a loan default (i.e.  job security, etc.).  If you’re considering taking a loan from your retirement plan, be sure to consult with the plan sponsor or plan administrator to confirm any guidelines and fees associated with the loan, and consult with your Benjamin F. Edwards advisor regarding your overall financial and retirement strategy.