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angelajett97
New Member

I have a 401K loan for $11,000 that due to job loss I'm going to need to default on the loan. Should I take out a loan to pay the 401k loan or just pay the penalty

at tax time.  My annual pay with the loan default will be around the same as my annual pay last year?  Need help on deciding what is the best option
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Opus 17
Level 15

I have a 401K loan for $11,000 that due to job loss I'm going to need to default on the loan. Should I take out a loan to pay the 401k loan or just pay the penalty

It will almost always be better from a long term point of view, to repay the 401(k).  You should have up to 60 days from the termination date to repay the loan. 

If you default, you will owe income tax (let's say 15% for most middle class taxpayers) plus the penalty (10%).  That's $2,750 taken out of your income tax next year, and then you are over and done with it.

If you take out a loan (let's say 5 years at 6% interest) your payments will be $212 per month.  Over 5 years (60 months) you will pay $12,720, which includes $1,720 of interest.  The interest you pay on the loan is already less than the tax on the withdrawal.  Then, by leaving the money in the 401(k), you have future growth for retirement.  In 20 years, $11,000 could conservatively grow to $36,412 (average 6% growth rate).

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It gets more complicated if we talk about opportunity cost.  Let's assume you have $212 per month to invest or use as a loan payment.  (If you don't, then you can't afford the loan and probably need to default and eat the taxes anyway.)

If you pay back the 401(k) and take the loan, then you owe no tax now, pay $212 per month for 60 months, and have $36,400 extra in the 401(k) in 20 years.

If you default, you owe $2750 in tax and penalties, which takes 13 months to pay off at $212 per month.  Then you can invest $212 per month for 47 months, and leave it sit for 15 years (same 20 year total time horizon).  Your investment account would have $28,800 in it.  That's an $8000 long-term loss by taking the default instead of the loan.

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And of course, if you are in a high tax state and the 25% (or higher) federal bracket, then it's even worse to take the default, because it costs you more in income tax this year.

*Answers are correct to the best of my ability at the time of posting but do not constitute legal or tax advice.*

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