How should I handle an open loan during my rollover?

Open loans in employer-sponsored retirement accounts are quite common. In fact, 13% of 401(k) plan holders have an outstanding loan.

As you roll over your old account with a loan to a new employer plan or an IRA, you have a few options:

1: Pay off the loan before rollover
You can repay the full amount of the outstanding loan balance with no tax or penalty right now. If you currently have the funds to pay off your loan balance before we begin your rollover, we highly recommend you do this. Once the loan is paid off, all your retirement savings can move to your new destination and start growing without any tax or penalty.
2: Rollover without paying off the loan
If you do not have all the funds to pay back your loan right now, we can still continue with the rollover. You can pay back the loan amount directly into your destination within the deadline without any penalty or taxes. If you never want to pay back the loan amount, then the loan amount would be considered as additional taxable income when you file your taxes for that year.

So, what is that deadline?

Effective Jan. 1, 2018, if the plan loan amount is due because of plan termination or severance from employment, a participant has until the due date, including extensions, for filing the Federal income tax return for the taxable year in which the offset occurs to rollover the offset amount. COVID has some more extensions in place for this deadline**

Example: Katie, age 45, leaves her job on February 15, 2021. She has an $85,000 401(k) account balance and a $20,000 outstanding loan balance. Katie is unable to repay the loan. She elects a direct rollover of her 401(k) account balance to an IRA. On March 31, 2021, the plan offsets her $85,000 account balance by the $20,000 loan balance and transfers $65,000 to her IRA. Katie has until October 15, 2022 to replace and roll over the $20,000. Otherwise, she will have additional taxable income of $20,000 and a $2,000 penalty.
3: Leave account as is (Don’t rollover)
Another option you have is to not rollover your account and leave it as is in your old employer plan. But please note that irrespective of the rollover, your loan will still be due as you no longer work with your old employer.

If you leave your job (whether voluntarily or involuntarily) with an unpaid loan balance, your former employer may allow you a period of time to pay off the loan. But if you can’t (or don’t), the plan will reduce your vested account balance in order to recoup the unpaid amount. As a result, the amount of the distribution (outstanding loan proceeds) will need to be included on your tax return for the year in which the distribution was declared. It will then be subject to ordinary income tax. But if you’re under age 59 ½ at the time of the distribution, you’ll also be subject to the 10% early withdrawal penalty tax.

So, please contact your old employer and confirm the repayment terms or be prepared for the tax and penalty. Leaving the balance as is will not solve your problem.