401K Default
My husband & I are in deep.... Way deeper than I think either of us would care to admit. We have 4 children, I am going to college full-time, & he works fulltime (lots of extra hours too!). A few years ago we had taken out money from his 401K , as a loan, to pay for our home down payment. We have about $11,200 left on this loan & are paying nearly $225 every 2 weeks on it. As we are currently on one income and strapped to the tee, we are considering trying to default on this loan. We realize we will lose the 10% on tax time, but the near $500 a month is worth it in our eyes. My question is... Can you just default on a 401K loan, while still employed with the company?
(2) Answers
Guru
Frazzled-Mom,
Yes, you can still default on your 401(k) loan while you are still employed with the company. The 401(k) plan will treat it as though you took a distribution from the account (because effectively, the plan WILL take a distribution from your account as collateral to satisfy the outstanding loan).
However, be cautious about the tax implications here. You will not "just" lose the 10% early withdrawal penalty on the loan principal. You will also be required to report the full amount of the loan in your income as well - potentially increasing your tax burden further. At a 25% marginal Federal tax rate, the cost of defaulting on this loan could be as high as 25% of the $11,200, plus the 10% penalty on the $11,200, for a total of almost $4,000 in taxes. And if you're in a state with income taxes, the state will want its share of income taxes on the $11,200 as well. If your tax rate is lower, the bite may not be quite as bad, but it could still be pretty painful.
So to answer your original question - yes, you can default on the 401(k) loan by essentially having them distribute enough money to pay it off. Contact the 401(k) provider and ask them how they would handle it to iron out any of the administrative details with your particular provider. But unfortunately, you should be aware that the tax ramifications can be pretty harsh, between both the income taxes AND the penalties due. :(
Depending on your overall situation, it may be advisable to try to find a different source of funds to tap to try to manage your current debts, if there's any other feasible alternative.
Best wishes to you in these difficult times.
Guru
Hello Frazzled-Mom,
Michael covered the tax issues, so I just wanted to reaffirm from another angle his excellent advice to explore other funds sources before defaulting on this 401(k) loan.
It sounds from your post that the main concern is that stiff $225 every-two-weeks payment. That's understandable: even on your $11K balance, that amounts to more than four percent of the principal per month...much higher than a mortgage payment or even credit card minimum payments.
One thing to check closely is the terms of your 401(k) loan. Some plans credit all the interest you pay on this loan to your 401(k) account, but others have less favorable policies. If yours are less favorable, that's all the more reason to find a source of funds other than the 401(k) if possible.
If your credit is good, one alternative might be to find a home equity line of credit, personal line of credit, or even a credit card "balance transfer offer" that could be used to help make the payments. It might even make sense to pay off the loan entirely through such means, if attractive rates are available to you.
One key point to remember here: 401(k) funds not only provide you with a retirement cushion, but they are also protected from creditors. So, in the unhappy event that things get worse and you have to file bankrupcy somewhere down the line, your 401(k) funds would almost certainly be protected. By defaulting on your 401(k), you effectively remove the funds from that protected pool.
As Michael said, best wishes to you and your family during these trying times.
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