Although the money saved in a 401(k) account is meant for an employee’s retirement, many plans allow participants to borrow from their account before they retire. Fewer plans allow former employees to borrow from their 401(k) after retirement, but there are no IRS regulations prohibiting it. If you are considering a 401(k) loan after retirement and your plan allows you to borrow, it’s important to understand how future distributions from the account could be affected by the loan.
Maintaining a 401(k) After Retirement
When an employee who has a 401(k) retires, the plan administrator has several options for handling the retiree’s account. The account balance may be paid out in a lump-sum distribution, or it may be paid out on a schedule over time. Another option is for the administrator to leave the 401(k) in place and allow the employee to make withdrawals on their own schedule. If the plan administrator continues to maintain the account, even after the employee has left the job, then it may be possible for the employee to borrow from the account if the administrator allows such loans.
Understanding How 401(k) Loans Work
Financial advisors typically advise against 401(k) loans unless you have a financial emergency since the loan could impact the amount of money you have for retirement. However, there are several advantages to this type of loan. No credit check is required and the interest rate is usually low. Unlike a normal 401(k) distribution, money received from a 401(k) loan is not taxable. One of the main disadvantages is that employed workers cannot contribute to their retirement account until any outstanding loan is repaid, so they are missing out on both the contributions and any earnings from it due to the loan.
How Much Can You Borrow?
If a 401(k) plan allows loans, the IRS limits the amount of money that can be borrowed to 50 percent of the vested balance or $10,000, whichever is greater. The maximum limit for this type of loan is $50,000. The IRS requires the loan to be repaid within 5 years, with payments for interest and principal being made at least quarterly. Under certain circumstances, such as taking out a loan to help buy your principal residence, the repayment term may be extended. It’s up to the plan administrator to set the length of the extension. The plan is also allowed to suspend repayment requirements while an employee is on active military duty.
Failing to Repay a 401(k) Loan
If you fail to make scheduled payments for a 401(k) loan, the entire remaining balance of the loan will be treated by the IRS as a distribution. Also, if you leave your job before repaying the loan, you have a limited amount of time to repay it or it will be treated as a distribution. A 401(k) loan that’s treated as a distribution is classified as taxable income by the IRS. In addition, workers below age 59 1/2 in this situation are subject to a 10 percent IRS penalty for early withdrawal from their retirement account. Retired workers with reduced incomes should carefully consider 401(k) loan repayment after leaving the job to avoid the tax penalties for defaulting.
401(k) Withdrawal After 60
Most 401(k) plan administrators do not offer loans to people who have retired because those people no longer have the salary provided by the employer and may be more of a credit risk. If you are age 59 1/2 or older and the plan administrator will not give you a 401(k) loan, it may make more sense to withdraw money from your 401(k) since you won’t be subject to any penalty for early withdrawal. Since a 401(k) represents pre-tax money, your plan administrator will withhold 20 percent of the withdrawal for income tax. After age 70 1/2, IRS law will require you to take minimum annual distributions from your 401(k) for the remainder of your life, or until all the money in your 401(k) has been distributed. If you are close to that age, you should carefully consider how much you withdraw or borrow since you run the risk of lowering your lifetime distributions.
Withdrawals for Early Retirees
The IRS has a special rule for people who are forced to leave their job or who retire or quit at age 55 or older. In this case, the IRS waives the 10 percent penalty for taking a 401(k) withdrawal before age 59 1/2. The 401(k) withdrawal is still taxable as a normal distribution and cannot be rolled over to an IRA to avoid taxes.
Alternatives to 401(k) Loans
Before taking out a 401(k) loan, whether retired or still working, you should look at other alternatives for borrowing. This is especially true if you want to pay off credit card debt or pay college tuition. Many banks offer low-interest alternatives. For example, a home equity loan may offer a similar interest rate and will not affect your retirement savings. Another thing to consider before taking a loan in retirement is whether you’re taking on too much debt, especially if your main source of income is fixed. The Consumer Financial Protection Bureau suggests that monthly payments for debt should be no more than 43 percent of your gross income.
Impact of 401(k) Loan on Retirement
Some 401(k) plan administrators freeze an employee’s contributions to a 401(k) while a loan on the account is being repaid. This action would not pertain to a retiree who was no longer making contributions. Even so, unless the market performs poorly while your loan is active, you may lose more in compound interest on the 401(k) money you borrow than you will pay in interest on a conventional bank loan. If you are unable to repay the loan on schedule, you could face a big tax bill when the outstanding balance is treated like a distribution by the IRS.
Borrowing From an IRA
Unlike a 401(k), borrowing from an IRA account is prohibited by the IRS. There are situations in which an IRA withdrawal can be made without the early withdrawal penalty for those under age 59 1/2, such as paying for college or buying a first home. It’s also possible to free up IRA funds for a 60-day period by rolling over an IRA balance from one account to another. If the money is not deposited within 60 days, it’s treated as a distribution by the IRS and you could face an early withdrawal penalty. As long as this penalty is avoided, an IRA rollover might be a good alternative for a retiree thinking about a 401(k) loan for a short-term cash flow emergency.
Consider a 401(k) Rollover
If you take a distribution from your 401(k) and roll it over to a qualifying IRA within 60 days, there are no taxes or penalties on the money transferred. Like an IRA rollover, this is an option for obtaining a short-term loan after retirement. If you already have an IRA, consolidating all your retirement funds in one account can be easier to manage. Just be sure to deposit all of the funds into the new IRA account in time to avoid taxes or an early withdrawal penalty if you are under age 59 1/2.
2018 Tax Law
The tax reform of 2018 offers some relief for taxpayers who default on a 401(k) or leave their job before repaying a 401(k) loan, including those who retire with an unpaid loan. You now have until the due date for your next tax return to pay the outstanding balance before it’s treated by the IRS as a taxable distribution. Previously, this type of loan had to be repaid within 60 days of leaving the job.
Catie Watson spent three decades in the corporate world before becoming a freelance writer. She has an English degree from UC Berkeley and specializes in topics related to personal finance, careers and business.