We discussed the 401(k) loan's 2 restrictions in last blogpost, now will discuss the exceptions.
Repayment Exception
If the loan is used to purchase a primary residence, the repayment period may be extended beyond five years at the discretion of the 401(k) plan, and is available as long as the 401(k) loan for down payment is used to acquire a primary residence — regardless of whether it is a first-time homebuyer loan or not. On the other hand, there is no limit or penalty against prepaying a 401(k) loan sooner.
If the employee is terminated or otherwise separates from service — where “immediately” is interpreted by most 401(k) plans to mean the loan must be repaid within 60 days of termination.
On the other hand, 401(k) plans do have the option to allow the loan to remain outstanding, and simply allow the participant to continue the original payment plan. However, the plan participant is bound to the terms of the plan, which means if the plan document specifies that the loan must be repaid at termination, then the five-year repayment period for a 401(k) loan — or longer repayment period for a 401(k) loan for home purchase — only applies as long as the employee continues to work for the employer and remains a participant in the employer retirement plan.
To the extent a 401(k) loan is not repaid in a timely manner — either by failing to make ongoing principal and interest payments, not completing repayment within five years, or not repaying the loan after voluntary or involuntary separation from service — a 401(k) loan default is treated as a taxable distribution, for which the 401(k) plan administrator will issue a Form 1099-R. If the employee is not already age 59 ½, the 10% early withdrawal penalty under IRC Section 72(t) will also apply, unless the employee is eligible for some other exception.
In our next blog post, we will discuss the key benefit of borrowing from 401(k).
Repayment Exception
If the loan is used to purchase a primary residence, the repayment period may be extended beyond five years at the discretion of the 401(k) plan, and is available as long as the 401(k) loan for down payment is used to acquire a primary residence — regardless of whether it is a first-time homebuyer loan or not. On the other hand, there is no limit or penalty against prepaying a 401(k) loan sooner.
If the employee is terminated or otherwise separates from service — where “immediately” is interpreted by most 401(k) plans to mean the loan must be repaid within 60 days of termination.
On the other hand, 401(k) plans do have the option to allow the loan to remain outstanding, and simply allow the participant to continue the original payment plan. However, the plan participant is bound to the terms of the plan, which means if the plan document specifies that the loan must be repaid at termination, then the five-year repayment period for a 401(k) loan — or longer repayment period for a 401(k) loan for home purchase — only applies as long as the employee continues to work for the employer and remains a participant in the employer retirement plan.
To the extent a 401(k) loan is not repaid in a timely manner — either by failing to make ongoing principal and interest payments, not completing repayment within five years, or not repaying the loan after voluntary or involuntary separation from service — a 401(k) loan default is treated as a taxable distribution, for which the 401(k) plan administrator will issue a Form 1099-R. If the employee is not already age 59 ½, the 10% early withdrawal penalty under IRC Section 72(t) will also apply, unless the employee is eligible for some other exception.
In our next blog post, we will discuss the key benefit of borrowing from 401(k).
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