A girlfriend recently found herself in an unfortunate situation. She was laid off from her job after she had just taken a loan against her 401(k). She had a few questions for me:
- What happens to the loan now?
- Does she have to pay it back in full immediately?
- Will they take the money out of the balance?
- Are there penalties?
What we discovered after some research is that she doesn’t have to come out of pocket for the loan money because the outstanding balance will be deducted from her 401(k) balance. We, also, discovered that she will be taxed on the loan as if it was a withdrawal. The loan amount is taxed at her tax level plus a 10% penalty will be assessed for early withdrawal from a retirement account. This was disconcerting to her because she felt like she was penalized for an event that was out of her control.
Taking a loan against your 401(k) should always be a last option for the reasons that were just cited above. Afterall, you will need this money is for your retirement someday.