Exiting Your Job with an Unpaid TSP or 401k Loan: What’s Next?

Leaving a job often brings about a whirlwind of professional and financial changes. Among these considerations, managing any outstanding 401k or TSP loans is crucial. Understanding what happens to your loan when you exit or retire from your job is vital for safeguarding your retirement savings and avoiding potential penalties. 

What Happens to Your 401k Loan When You Leave Your Job?

When you quit your job, your usual method of repaying the loan through payroll deductions disappears. Most plans require repayment within a specified timeframe after termination, typically within 60 to 90 days. Failing to meet this obligation can have significant tax consequences. Moreover, each 401k have their own set of rules so you will need to verify the timeframe with the plan provider or administrator. 

Consequences of an unpaid loan when you leave your job

Failing to repay the loan by the deadline can result in various consequences. Firstly, the outstanding loan balance is treated as a distribution, resulting in you owing income tax based on the loan amount. Early withdrawal penalties (10% of additional tax) may apply if you’re under age 59½.

What if You Have A TSP Loan When You Leave Federal Service

If you have a TSP loan when you separate or retire, you face the same potential income tax and penalty if you are under age 59 1/2. However, the new rules from the TSP state that you can set up a monthly payment plan and pay off the loan by a required deadline. Moreover, you can pay off the loan in a lump sum to avoid the monthly payment. 

How Does an Unpaid TSP or 401k Loan Affect Your Retirement Savings?

The repercussions of an unpaid 401k loan extend beyond immediate financial implications. Not only does it reduce your retirement account balance, but it also disrupts your retirement savings strategy. This shortfall can disrupt your retirement planning and delay your financial goals. 

Tax implications of defaulting on your loan

While the default does not require you to make any payments or have any credit impact, it does count as a taxable distribution.  For example, let’s say that you have a $40,000 loan balance that defaults.  You need to pay income tax based on the $40,000.  Assuming 20% Federal tax rate and 5% state tax rate, that’s a total tax bill of $10,000.  Moreover, you may need to take additional funds from your retirement account to cover living expenses if you are not working or retired. That means you might be pushed up to the next tax bracket depending on what retirement income you will receive. 

Can You Rollover Your 401k or TPS Loan to an IRA or Another Plan?

The answer is NO!  You can not rollover a loan from an employer plan to an IRA or another employer plan.  In fact, IRA guidelines do not allow any loans whatsoever.  If you have a loan inside the IRA, that is a major violation of IRS rules, and your entire IRA account could be immediately subject to income tax. 

Strategies to Pay Back Your 401k or TSP Loan

The best strategy is to pay back the outstanding balance immediately. You want to contact the plan administrator to find out the timeframe and due date.  Then, you need to review your income for the year and consult a tax advisor to review the overall impact since an unpaid loan balance is considered taxable income.  While the best way to pay off the loan is using available cash or investments, you can also consider other loan options, such as a home equity loan, to pay back the loan. While using one loan to pay off another loan seems like a bad idea, it may be beneficial if you can spread out the tax liability over multiple years.