Originally created 02/08/98

Money Line

Q: I have left my previous employer and I had already borrowed against my 401(k), and my previous employer has told me that it has to be a distribution, and that distribution will fall under the 20 percent federal tax penalty and the 10 percent early-withdrawal penalty, even though I left my employer as a downsizing and it wasn't on my own. ... The balance of the loan is $22,000, and for them to make me pay that back within 30 days after leaving the company is just unreasonable and unrealistic. -- J.G., Norwood, Mass.

A: Let your experience serve as a warning to workers everywhere: Unless your jobs are secure -- and few are nowadays -- think twice before borrowing money from a retirement savings plan at work known as the 401(k) plan.

Why? If you borrow from your plan, then leave your job for whatever reason (even if it's involuntarily, through downsizing, for example), the outstanding balance on your loan will generally be considered a withdrawal (technically called a "distribution") for tax purposes, said Frank Roche, a principal in the Boston office of Buck Consultants Inc., an international human resources consulting firm.

There are exceptions:

-- Your employer may give you time to pay off the loan to avoid tax consequences. "Thirty days is not uncommon," Mr. Roche said. (If you pay off the loan, you can later withdraw your entire 401(k) plan balance and either transfer it to an Individual Retirement Account or to another employer's plan to avoid tax problems, he said.)

-- Some employers may let a worker keep paying on a 401(k) loan until it's paid off -- even after the worker has left the job, said Henry DeSantis, associate regional director of the Pension and Welfare Benefits Administration. "There's nothing to keep a plan from letting a loan stay on its books as long as you keep paying according to schedule," he said. But it's up to the employer.

If these exceptions don't apply to you, you could trigger tax complications: For tax purposes, the loan won't be a loan anymore; it'll be treated as if you had simply withdrawn the money.

So, in the end, you may wind up paying federal income tax on that amount. (You may owe state income tax, too, depending on where you live.)

In addition, if you're under age 59 1/2 , you may have to pay a 10 percent federal income-tax penalty, Mr. Roche said.

So, in your specific case, if you're in the 28 percent federal income tax bracket, you'll have to pay $6,160 in federal tax on your "withdrawal." And if you're under 59 1/2 you'll have to pay a $2,200 penalty. Total tax bill: $8,360.

(The "20 percent" to which you refer is the amount your employer must withhold from the rest of your 401(k) account and send it to the government, to help cover your tax bill.)

The bottom line? "Don't take a loan from your 401(k) unless you have the cash to cover it" if you were to lose your job, Mr. Roche said. In other words, "Don't use your 401(k) plan for loans unless you could repay the loan from some other source if you lost your job."

And keep in mind that 401(k) plans are to help supplement your income in retirement, Mr. DeSantis said; they're not intended to be credit cards.

TODAY'S TIP: Leaving your job and wondering what to do with your retirement money?

Fidelity Investments of Boston, the nation's largest mutual fund company, has a 21-page booklet that explains your options.

"Leaving or Changing Jobs?" is a plain-language guide that shows how much in taxes you'll face if you simply withdraw the money, why reinvesting your money may be a better option, and what your reinvestment choices are.

For your free copy, call (800) 544-4774. Your request won't result in any follow-up sales pitches by phone or mail, said Fidelity spokeswoman Gwenn Gauthier. (Fidelity may send one follow-up letter to confirm that you received your booklet, she said.)

Neil Downing is a writer for the Providence Journal-Bulletin in Rhode Island. Do you have a question about your money matters? Write to MoneyLine, c/o Business News, The Augusta Chronicle, P.O. Box 1928, Augusta, GA 30903. Mr. Downing can't reply personally, but as many questions and issues as possible will appear in his column.


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