In this economy, many of us are learning painful lessons. For some laid-off workers, one lesson learned is why it can be a bad idea to borrow money from your 401(k) retirement savings account, particularly when your job could be at risk.
Consider the lesson learned by a Michigan woman.
Q: I recently became unemployed through layoff due to a lack of work. I have an existing 401(k) loan with my former employer. My understanding is the loan is in default within 60 days of loss of employment.
My question is: Is there any way to continue to make loan payments in the agreed upon amount (previously payroll deduction) to prevent loan from being in default? If I continue to make the agreed upon payments on time, I do not understand why I am in default. I am still agreeing to pay the loan. Can my checking account be used for "401(k) loan automatic loan repay deduction" or can my husband who is employed have payroll deduction to continue to pay for my 401(k) loan?
I do not understand if I am able to continue to pay my 401(k) loan on time in the original agreed upon amount, why is the loan in default? I understand if I am ever late or miss a payment the loan would then be considered in default. A person should be able to make an effort to pay the loan off before being penalized especially in this tough economic time when banks are not lending etc. - L.B. Waterford, Mich.
A: L.B., you are encountering an unforgiving reality of 401(k) loans. And that reality is that in most cases, when you leave a job – whether by choice or by force – you will need to cough up some cash to pay off any outstanding 401(k) loans.
At the worst possible time, you are being told you must come up with $5,000, $10,000, $20,000 or more to pay off the loan that at one time seemed like a good idea. If you can't come up with the money, the loan will be declared in default and you will be hit with taxes and penalties that add insult to the injury of losing your job.
In a moment, I will review the rules in detail, but first let me pause to say there are exceptions to this situation and, if you are lucky, they could apply to you.
Some 401(k) plans will allow borrowers to continue paying off the loan after they stop working for a company that sponsors the plans.
At one company I'm familiar with, employees who leave can make arrangements to continue making monthly payments to the outside provider that administers the company's 401(k) plan.
In your case, L.B., I would first check to see if your 401(k) plan has such a provision. This could provide the answer you are looking for.
Check with the human resources office of your former employer, and also check with the company that runs the 401(k) plan. If you have trouble getting answers, ask for a copy of the Summary Plan Description that every 401(k) plan is supposed to have. In that document, there should be a section that addresses loans and what happens when a 401(k) borrower leaves the company.
There's no actual requirement that 401(k) plans make loans available to participants. The IRS rules allow them to be made, but it's totally up to the companies that sponsor these retirement savings plans.