When contributing to a 401(k) plan, most people have every intention of accumulating a sufficient retirement nest egg that they can live off in retirement. However, when heavy financial emergencies occur and you do not have an emergency fund, you could be forced to raid your retirement savings to settle the urgent financial needs.
Most 401(k) plans allow you to take a 401(k) loan against your retirement savings, or a hardship withdrawal if you are below 59 ½. However, there are circ*mstances when you can withdraw from your 401(k) if you have an unpaid loan. For example, if you leave your job or are fired, you could rollover your 401(k) to an IRA or the new employer’s 401(k) even if you have an outstanding 401(k) loan. When this happens, the outstanding 401(k) balance will not be rolled over, and you will have until the tax due date to pay off the loan balance.
Circ*mstances When You Can Withdraw from a 401k if You Have an Outstanding Loan
Each 401(k) plan has different rules on 401(k) loans and 401(k) withdrawals. If your employer’s 401(k) plan allows employees to tap into their retirement money, you may be required to provide some proof to document that you are in an urgent financial need to get approved. The approval process is rigorous since allowing frivolous withdrawals puts the 401(k) plan at risk of losing its tax-favored status.
Some of the circ*mstances when you could withdraw money from your 401(k) plan if you have an unpaid loan include:
Roll Over 401(k) If You Have an Outstanding Loan
If you terminate employment with an outstanding 401(k) loan, you can rollover the money to an IRA or new employer’s 401(k). As long as the loan repayment was in good standing, the employer will rollover your retirement money net of the outstanding 401(k) loan. You will have until the tax due date to pay off the 401(k) loan balance.
For example, assume that you have a $50,000 vested 401(k) balance, including an outstanding 401(k) loan of $15,000. If you quit your job and request the plan sponsor to rollover the retirement savings to your new IRA, the plan sponsor will reduce the vested 401(k) balance by the $15,000 outstanding loan, and disburse the remaining $35,000 to your IRA. You will then have until the tax due date to come up with the $15,000 outstanding loan, after which you can rollover the $15,000 401(k) balance to your IRA.
Cash out 401(k) with an Outstanding Loan
If you quit or get terminated from your job, you can cash out your net outstanding balance minus any unpaid 401(k) loan. If your 401(k) balance at the time of terminating your employment was less than $1000, this amount will be automatically cashed out and the employer will send you a check with your balance. If you have an unpaid 401(k) loan, you will have to repay the amount by the tax due date of the following year. If you had defaulted on the 401(k) loan before the termination date, the employer will deduct the defaulted amount from the participant’s vested account balance, and cash out the remaining amount. The defaulted loan amount is treated as an early distribution, and you will pay tax on the unpaid amount, in addition to a 10% penalty if you are below 59 ½.
Take a Second loan with an Outstanding Balance
If you have a 401(k) loan, you may qualify for a second 401(k) loan even if you are still repaying the first loan. To determine the amount you can borrow as a second loan, you must determine the allowable loan limit based on the IRS rules. The IRS provides that a participant can borrow a maximum of $50,000, or half of their vested account balance, whichever is smaller.
For example, assume that the maximum loan amount you can borrow from your 401(k) plan is $50,000, and you have an outstanding loan balance of $10,000. The highest outstanding balance for the last 12 months was $35,000. When determining the amount you can borrow for the second loan, the plan sponsor considers the highest outstanding loan balance for the last 12 months. Therefore, the amount you can borrow is calculated by taking the maximum loan you can borrow i.e. $50,000 minus $35,000. This means you can borrow up to $15,000, while still repaying your original loan.
