401k loan, laidd off, unable to payback

[NABRIL]

Hello
Recently laid off, and I have outstanding balance in 401k loan. I am given 90 days to pay it back after the official termination. The balance is about $10k, and we dont have the full amount; I could reduce it a bit, but not all.
The purpose of that loan was to give a down payment on a new home. I had an apartment when I was single, and after marriage bought a bigger place.

I will obviously get the respective 1099 or whatever form for the $10k withdrawal.
1) Can I claim this as an acceptable early withdrawa?
2) If so, how do I state that? In next year's tax return? As a qualified early withdrawal.
3) No investment will give me 10% return on the money I will get as part of the severance package. SHould I put it all towards paying this off, or the answer to #1 will determine that?

Thanks,
N

[jIM_Ohio]

I would pay off the loan with severence proceeds.

I am unsure if house qualifies as a reason to take a hardship withdraw, I would look up on IRS website.

[sweeps]

Yes, you should be able to consider it a withdrawal. (Check your 401k plan documentation to find out for sure and how to do it.) However, note that you will still be subject to the 10% withdrawal penalty. Apply your severance to paying off the loan if you can afford it to avoid taxes and the 10% penalty.

[kv968]

I would check with your employer or a tax preparer to see if it qualifies as a hardship withdrawl. A withdrawl designated as being used towards a down payment for your primary residence is usually considered a hardship withdrawl. However, since it was in the form of a loan, I'm not so sure it could be considered one now. To me it should be, but who knows with the gov't? I'd check with your employer first. If it doesn't qualify then you're going to own the 10% early withdrawl fee if you're under 59 1/2 plus all applicable fed, state and local taxes also.

[sweeps]

Withdrawals for the purchase of a primary residence are still subject to 10% penalty. The list of hardships that are exempt from the 10% penalty is pretty limited.

[kv968]

Originally Posted by sweeps

Withdrawals for the purchase of a primary residence are still subject to 10% penalty. The list of hardships that are exempt from the 10% penalty is pretty limited.

Looks as if the taxes are still applicable too. No offense to the OP, but this is one of the main reasons you shouldn't take a loan against your 401k.

[zetta]

Would it be possible to take a home-equity loan against your house to pay off the $10k (or the remainder after you reduce it?) And would you be able to make the payments while living on your unemployment and spouse's income? If you could swing it in the short term, this would allow you to avoid both the penalty and taxes.

How much would be left on the loan if you apply all your severance to it? And do you have enough of an emergency fund to live on until you are likely to find another job if you do so? Maybe the boards can help you think of creative ways to pull together the remainder...

[kv968]

Actually, even if it doesn't qualify as a hardship withdrawl, I think you'd be better by not paying anything on it and just pay the taxes and early withdrawl penalty.

Granted, tax brackets aren't this cut and dry, but for example...

If you didn't pay anything back on it, then that would be $10,000 extra income and a 10% penalty. If you're in a 25% tax bracket that would be $2500 taxes + $1,000 penalty = $3500 owed on it. If you're in a 15% tax bracket it would be $1500 taxes + $1000 penalty = $2500 owed.

If you put say $3000 towards the loan and drop it down to $7000, in a 25% tax bracket that would be $1750 taxes + $700 penalty = $2450 owed. 15% bracket would be $1050 taxes + $700 penalty = $1750 owed. So for paying $3000 of the money back, you would only save $2450 to $1750 in tax and penalty savings depending on which tax bracket you're in.

I would say just claim it as income if it doesn't apply for hardship status. If anyone sees anything wrong in my logic or math please let me know. Of course by not paying it back, you can't get that money back into the 401k.

[sweeps]

The loss is the $1,000 early withdrawal penalty. Assuming a 20% tax rate, OP either gets $7,000 ($10,000 - $2,000 taxes - $1,000 penalty) now or lets $8,000 ($10,000 - $2,000 deferred taxes) continue to grow tax deferred.

But kv I think your point is valid.... If OP is concerned about cash flow because he or she may be out of work for a while, it may be worthwhile to eat the $1,000 penalty.

[b4freedom]

Your first sin was borrowing against your retirement.

Your second sin will be not paying it off.

Pay it off.

Let's assume that you're in the 15% tax bracket. You pay 10% penalty and 15% taxes. You pay $2500 for your first sin and your left with $7500. Which you'll spend and you'll then have nothing.

Or, you pay off your $10,000 debt and you still have $10,000 that will turn into $126,000 (8.5% rate over 30 years). You still have something. Of course, you'll have to struggle for a month or two and maybe get your butt off the couch to pick up some odd jobs to help cover the bills while your unemployed. And worse case scenario: you borrow the money again to cover more dumb financial decisions. But if you don't pay it off, you won't have it to borrow again.

Rule of thumb: Never borrow against your future security.

[zetta]

Another thing to consider -- what is the timing of when the penalty plus taxes will be due? Are they due immediately, or next April when you file 2007 taxes?

I think it all comes down to what is your larger plan for weathering the period from now until you find another job.

[disneysteve]

Originally Posted by zetta

Would it be possible to take a home-equity loan against your house to pay off the $10k (or the remainder after you reduce it?) And would you be able to make the payments while living on your unemployment and spouse's income? If you could swing it in the short term, this would allow you to avoid both the penalty and taxes.

I think this makes the most sense. You borrowed the money to buy a house, so that implies you now have some home equity that you could borrow against. I would do whatever I could to avoid the early withdrawal penalty. Of course, this assumes that you can afford to live until you find work again.

[NABRIL]

thank you all for the comments. lots of options. Looks I will take the tax hit if I don't pay. I agree, if I put it in my checking account, it will get spent, and we will never see it. I have no losses to offset the additional income, so paying it will prob be the best solution. I do have a HELOC open, but would rather not touch that. I think i will pay down half of it or maybe $6k, and that way i reduce the penalties, and I have some cash to play with.

N

[disneysteve]

Originally Posted by NABRIL

I do have a HELOC open, but would rather not touch that.

WHY? Wouldn't it be better to tap the HELOC and not pay the early withdrawal penalties?

[NABRIL]

steve
touch a heloc at 7.5 to pay off a 10% "loan". Yes, on paper makes sense, but not sure if practical. Been trying to reduce that heloc for 3 years since we first got it at 3.9%.
i know, $3500 in taxes is a chunk. i know.

also. would the withdrawal apply to next year's taxes? or when i actually received the money from the loan, oct 2004?

[zetta]

Look at it this way -- you are actually just transferring the loan from the 401k to the HELOC, and avoiding up to $3500 in tax and fees.

If you can use the severance to pay $6k, that leaves $4k. Instead of paying the tax man $3500 next April, you could use that money to almost wipe out the debt.

Plan A -- pay off $6, don't pay off the rest
Your penalty would be $400, and taxes approximately $1000. So you lose $1400 out of pocket, plus the growth of that $4k from now until retirment.

Plan B -- transfer $4k to HELOC
At 7.5%, you could pay $125/month and have the $4k paid off in 3 years time. Total interest cost to you: $480 (and the interest may be deductible). Want it gone sooner? For $180/mo it will be gone in 24 months, for $235/mo it will be gone in 18 months.

If you've got the HELOC in place, and can make the payments, this really is the way to go.

[disneysteve]

Originally Posted by zetta

you are actually just transferring the loan from the 401k to the HELOC, and avoiding up to $3500 in tax and fees.

That is a perfect way to describe it. Thank you. So it is basically just a balance transfer. Instead of owing the money to the 401K, you will now owe the money to the HELOC. The difference is you avoid the penalties. I really don't see any downside to doing that.

[NABRIL]

Disney Steve and zeta
I have returned to this, as the time to pay is quickly approaching, and doubts remain.
I had assumed that i could pay part of the 401k loan back, but that was a wrong assumption; I have to pay all or nothing.

So, that changes things.

Both of you presented very valid/reasonable arguments for transfering the loan to the heloc, but I am still not 100% sure about that. User b4freedom suggested putting it back so that it grows to a nice large number--he seems very conservative.

If i understand zetta correctly, he suggests paying the 401k with the heloc (avoiding the penalties), and then using the severance to pay off some or part of the heloc? Is that correct? I just dont want the severance money to sit in my checking and wither away. Yes, I remain unemployed, and that distorts the topic altogether!!

thanks all

[disneysteve]

Originally Posted by NABRIL

Both of you presented very valid/reasonable arguments for transfering the loan to the heloc, but I am still not 100% sure about that.

If i understand zetta correctly, he suggests paying the 401k with the heloc (avoiding the penalties), and then using the severance to pay off some or part of the heloc?

I think that is the best way to go. Of course, that assumes you don't need the severance to live on since you are still unemployed. In either case, it makes a whole lot more sense to do the HELOC than to pay the penalties on the 401K loan.

[NABRIL]

Steve
I agree with you. By using the HELOC to pay for it, I have the freedom to pay all or part of it (which the 401k doesnt allow). And the interest is tax deductible.
The interest on the heloc will (hopefully) always be lower than the 10% penalty, so that makes it a good choice as well.

Thanks again,
N