July 28, 2009 -- 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.
Many employers allow 401(k) loans as a way to encourage workers to sign up for the plan, but they are just one more administrative headache and expense. That's why even if a company is willing to take on the burden for current workers, it's less likely to do so for former employees.
Quite honestly, L.B., I would be surprised if your 401(k) plan allows you to continue making payments on your loan rather than requiring you to paying it off all at once. But it's something you definitely you should research.
In most 401(k) plans, borrowers are required to pay off their loans when they leave a company, usually within 90 days.
If that payment is not made within the specified period, then the amount left owed on the loan is treated as a standard withdrawal that is subject to federal and state income taxes plus a 10 percent early withdrawal penalty is the borrower is less than age 59½.
For example, someone with $10,000 outstanding on a 401(k) loan when they lose their job faces the prospect of forking over that $10,000 when they need the money most – or possibly owing as much as $4,000 in taxes and penalties on the default amount. That could mean a scramble come April 15 of the following year when those taxes are due.
Either way, it's a choice between bad and worse for someone who has lost their job.
A recent Federal Reserve Board research paper took note of this cruel choice and suggested changes to the way 401(k) plans are structured.
Fed researchers Geng Li and Paul A. Smith proposed that 401(k) loans be made "portable" across employers, allowing the account balance and loan servicing move with employees when they change jobs. Also, they suggested, former employers could be required to continue servicing the loans of laid off workers so these unemployed workers aren't forced to come up with the money at the worst time possible.
"Given that 401(k) loan programs exist, it seems appropriate to design them in a way that minimizes financial risks to participants and maximizes 401(k) participation and contributions," Li and Smith wrote.
To that, I'll say, "Amen."
Unfortunately, such changes are unlikely to be in place anytime soon to help L.B. and others like her.
This work is the opinion of the columnist and in no way reflects the opinion of ABC News.
David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at email@example.com.