Avoiding Taxation of 401(k) Loan

Hopefully you already know this – if you have a loan from your 401(k) plan and you leave employment, either on your own or if you’re terminated, the loan is considered a distribution from your plan, and therefore taxable. It’s important to note – this only applies when you leave employment.

Here’s an example:  you have a 401(k) plan with a balance of $200,000. You wish to take a loan from the plan in order to pay for your child’s college tuition – and so you take a total of $20,000 from the plan. It’s your intent to pay this off over the course of the next couple of years with the proceeds from some appreciated stock – you were delaying the sale of the stock since the stock is poised to run up quickly in the next year or so. Unfortunately, two months later your company decides to let you go – downsizing and all, you know.

Rather than calling the 401(k) loan due and payable immediately, the loan is classified as a distribution – meaning that, not only are you out of a job, you’ve got an extra $20,000 of income that will be taxed now, money that you’ve already spent on tuition. If you’re under age 55 (yes, 55, since you’re eligible to take a distribution after age 55 without penalty after leaving employment), the funds will also be subjected to the 10% early distribution penalty. Topping off the fun facts here is that you likely didn’t think to have any additional tax withheld or an estimated tax payment made, so you’ll likely get hit with a penalty for under-withholding of tax when you file.

So what can you do?

Since you have the appreciated stock (or really, funds from any other source), you can roll over the substituted funds into an IRA. The rule used to be that this had to occur within 60 days, but since the beginning of 2018, you have much longer to take care of this rollover. You can actually delay this rollover until your tax filing deadline for the year, including extensions, as you complete the rollover without penalty. This will effectively negate the distribution, and no tax or penalty will be owed.

Of course, if you sell appreciated stock you will owe tax on the capital gains – but presumably this is far less than the ordinary income tax (plus the penalties!) on the loan. If the capital gains tax is significant you’ll want to either adjust withholding for the remainder of the year and/or make estimated payments of tax in order to avoid the penalty for under-withholding. If you’ve delayed the rollover into the following year (2022 in our example), you can avoid the capital gains taxation until the end of that tax year as well.

Rounding out the example, let’s say you took the loan in January of 2021, and in March you were let go from your employer. You actually have until October 15, 2022 (yes, next year!) to fully rollover the loan balance into an IRA in order to avoid the taxation and penalties associated with the distribution. If you encountered capital gains taxes in producing the money to rollover, you could wait until as late as October of 2023 to pay that tax.

You should consider the additional impacts of taking this distribution – see the article Not So Fast! 9 Special Considerations Before Rolling Over Your 401(k) for more details on what you need to keep in mind as you make a rollover from your 401(k).

The post Avoiding Taxation of 401(k) Loan appeared first on Getting Your Financial Ducks In A Row.

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