Stuck With a 401K Loan and Leaving Your Job

Have you taken a loan from your employer 401(k) plan and plan on leaving? Unfortunately, most company plans will require you to repay the loan within 60 days, or they will distribute the amount outstanding on the loan from your 401(k) account. Its one of the ways they try to keep their employees from leaving. “Don’t leave or we’ll distribute your 401(k) loan that you took from your money in your 401(k) account.”

How to Buy Yourself More Time & Avoid the Distribution

The good news is that following the Tax Cuts and Jobs Act (TCJA) you now have the option to re-pay the loan to an IRA to avoid the distribution and you have until your personal tax return deadline of the following year (including extensions) to contribute that re-payment amount to an IRA. By re-paying the amount outstanding on the loan to an IRA, you will avoid taxes and penalties that would otherwise arise from distribution of a participant 401(k) loan.

How It Works In Practice

Let’s say you left employment from your employer in February 2019 and that you had a 401(k) loan that was distributed by your employer’s plan following your termination of employment. You will have until October 15th of 2020 (if you extend your personal return, 6 month extension from April 15th) to make re-payment of the amount that was outstanding on the loan to an IRA. These funds are then treated as a rollover to your IRA from the 401(k) plan and your distribution and 1099-R will be reported on your federal tax return as a rollover and will not be subject to tax and penalty. While it’s not perfect it’s far great time than was previously allowed. Traditionally, you had 30 or 60 days at most to try to make re-payment.

Limitations

The ability to rollover an outstanding 401(k) loan amount to an IRA is only available when you have left an employer (for any reason). It does not apply in instances where you are still employed and have simply failed to re-pay the loan or to make timely payments.

Penalty-Free Early IRA Distributions for College Education Expenses

Students walking across the campus of Duke UniversityDo you have tuition or other college expenses due for yourself, your spouse, or your child? Would you like to use your IRA to pay for these expenses? Would you like to avoid the 10% early withdrawal penalty for accessing your IRA funds before you are age 59 ½? This article outlines how you can avoid the 10% early withdrawal penalty when using your IRA to pay for higher education expenses.

Whether you should actually take a distribution from your IRA to pay for the higher education expenses of your child is another topic. Sadly, too many parents have raided their own retirement savings to pay for their children’s college education expenses. They then reach retirement age with a sliver of what savings or retirement accounts they could’ve otherwise relied on. Everyone’s situation and goals are unique but if you have decided to use IRA funds to help pay for educational expenses here’s how you can avoid the 10% penalty for accessing your own money.

10% Penalty Exception Rules for Higher Education Expenses

Here’s a quick breakdown on how the 10% withdrawal penalty can be avoided when you use IRA funds to pay for qualifying higher education expenses.

1. Who can the IRA money be used for?

 Your IRA funds may be used for qualifying higher education expenses of the IRA owner, their spouse, children, and their descendants.

2. What schools qualify?

Any school eligible to participate in federal student aid programs qualifies. This would include public and private colleges as well as vocational schools. Any school where you, your spouse, or your child completed a FAFSA application will qualify.

3. What expenses qualify?

There is a broad list of qualifying expenses. These include tuition, fees, books, supplies, and equipment. Also, room and board is included if the student is enrolled at least halftime.

4. How much is exempt?

The amount of your distribution that is exempt from tax is computed in three steps. First, determine the total qualifying expenses (tuition, fees, books, room and board, etc.) Second, reduce the qualifying expenses by any tax-free education expenses. These include Coverdell IRA distributions, federal grants (e.g. Pell grants), and any veterans or employer assistance received. Third, subtract and tax-free education assistance from the total qualifying expenses incurred and this gives you the total qualifying amount that you may take an early withdrawal from your IRA and avoid the 10% penalty.

Example

Here’s a quick example to illustrate theses rules: You’re age 53 and have an IRA you’d like to access to help cover your daughter’s education expenses. Your daughter Jane is attending Harrison University, a private college that participates in federal student aid programs.

Her expenses for the year are as follows:

  • Tuition: $22,000
  • Room and Board: $13,000
  • Books: $1,000
  • Supplies: $500
  • Equipment: $500
  • Total Qualifying Expenses: $37,000

Jane received the following aid:

  • Federal Grant: $2,400
  • Coverdell IRA Payment: $5,000
  • Federal Student Loan: $10,500 (loans do not reduce the qualifying expenses)
  • Total Tax-Free Assistance: $7,400
  • Total Amount Eligible for a Penalty-Free 10% Early Withdrawal: $29,600

You decide to take a $10,000 withdrawal from your IRA. Since the total amount eligible is $29,600, the entire distribution will be penalty-free. Keep in mind that while the $10,000 distribution is penalty-free it is still included into the taxable income of the IRA owner.

For more details on the 10% early withdrawal exception for higher education expenses, refer to IRS Publication 970. Also, the above example presumes the IRA owner has a traditional IRA. If the IRA owner has a Roth IRA, there are different considerations and distribution rules.