Taking a 401(k) Loan? Here's the Potential Job-Loss Tax Bomb Hiding in the Repayment Deadline

A 401(k) loan lets you borrow against your retirement account without withdrawing funds. That lets you avoid the immediate taxes and penalty fee that can come with typical withdrawals.

But a 401(k) loan can also result in a major tax bomb if you aren’t careful. A job loss can lead to forced withdrawals that are treated as ordinary income and incur penalty fees, if applicable.

Why 401(k) loans can feel safer than withdrawals

If you have a traditional 401(k), any money you withdraw will be treated as ordinary income. But taking out a 401(k) loan is not a taxable event.

The maximum loan amount is $50,000 or 50% of the vested account balance, whichever is less — though some plans let you borrow up to $10,000 if your balance is below $10,000. You typically have a five-year repayment period, unless you are taking out money to buy a house. Quarterly payments are expected.

This arrangement can work for some people, but there are risks. Though not common, some plans do not let you make contributions if you have a loan against it, which causes people to miss out on the employer’s match.

Another risk is getting laid off unexpectedly as the deadline to repay your loan typically accelerates. Health issues, caregiving responsibilities or an early retirement package can also lead someone to leave the workforce earlier than expected. If you get laid off or quit your job, the balance on your 401(k) loan becomes due immediately, and you typically have 60 to 90 days to pay it off.

The job-loss deadline that can turn a loan into a tax bill

While your 401(k) provider will likely give you a 60-to-90 day deadline to pay off the loan with outside funds, if the loan remains unpaid, the administrator can use your 401(k) balance to pay off the loan. That is treated as a withdrawal for tax purposes, which can push you into a higher tax bracket and make a layoff even more difficult.

A 10% penalty fee also typically applies if you are younger than 59 ½ years old.

How near-retirees can reduce the risk before borrowing

Taking out a 401(k) loan can make sense in certain situations, especially if you can pay it back quickly — though you should still plan for what happens if you get laid off or have to leave your job.

You can prepare for that scenario by asking the plan administration what happens to the loan if employment ends. Some companies let you continue repayment after separation, keeping the loan’s terms intact without it becoming due immediately. It’s also important to verify if you can still contribute to your plan after taking out a loan against it.