If you have taken out a loan from your 401(k) retirement savings and then quit or lose your job, you must repay the loan, typically within two months. If you can’t repay the loan, you could be hit with a big tax bill and a penalty.
If the loan isn't repaid, you should receive a Form 1099-R, which would list the amount of the early withdrawal (Box 1) and how much of that amount is taxable income (Box 2a).
TurboTax should calculate the 10 percent penalty and apply it to your return.
General lending rules
Many companies allow workers to borrow a portion of the money they have saved in their 401(k) retirement plans, but loans must be repaid within five years.
Loan amounts limited
Under IRS rules, your maximum loan amount is limited to:
Whichever is more, $10,000 or 50 percent of your vested account balance -- as long as it is less than $50,000.
For example, a plan participant who has an account balance of $40,000 can borrow as much as $20,000.
However, if you quit, are laid off your job, or your company closes its doors before you repay your loan, the IRS will consider your loan an “early distribution” of retirement savings.
- The loan’s outstanding balance will be treated as income to you and you will be required to pay taxes on it. If you have a loan balance of $20,000, you could owe federal income taxes ranging from $2,000 to $7,000 or more, depending on your tax bracket. For example, if you are in the 28 percent tax bracket, your taxes would be $5,600. State taxes could also apply.
- You will also be charged a 10 percent early withdrawal penalty, if you are under the age of 59 ½. Using the example of a $20,000 loan, the penalty would be $2,000 in addition to the income tax.
To avoid further taxes and penalties, keep any remaining money in your 401(k) account (if your company allows) or roll it over to an IRA or other retirement account.
Taking a loan against your 401(k) is different than taking a hardship distribution. Read Withdrawing Money From Your 401(k) Plan As a Hardship Distribution, for more information.