Plan Loan PITFALL
Before you borrow from your 401(k) plan account, it’s important to understand what you might be up against if you leave your employer before you finish repaying the loan. A recent Tax Court case illustrates a potential pitfall.
A participant in a 401(k) plan left one job for another but was laid off within the year. When he left the first job, he had an outstanding 401(k) plan loan. Shortly after losing the second job, he requested a distribution from his 401(k) account. He understood that his loan would have to be repaid before he could receive a distribution from his account. But he didn’t fully understand the tax consequences.
Since the participant didn’t repay the loan out of pocket, the plan administrator reduced the amount distributed to him by the amount he still owed. This “plan loan offset amount” was taxable. Worse yet, because the participant was only 49 years old, he had to pay an additional 10% penalty on the amount. The court noted that there is no exception to the 10% penalty for general financial hardship.