Here is a valuable tip for any of you moving from a career job where you have a 401(K) with a loan against it. Many workers today are moving to self-employment (say a consultant or real estate agent, for instance) and do not expect to have employees. In such cases the possible penalties on your 401(k) loan can be especially challenging, so you should consider a strategy for dealing with the loan before you leave your job.
Let’s say you have a maximum $50,000 loan on your 401(k). By definition, this tells us that you had at least a $100,000 401(k) balance at the time of the loan.
If you terminate your employment through retirement or discharge, your employee 401(k) loan becomes a taxable event. If you are under 59 years old, the penalty for early withdrawal is 10%, plus you would need to pay ordinary income tax on the $50,000 at your maximum rate.
For our example we will assume your adjusted gross income is $125,000 which would tax your highest earnings at 28%. You are in for a total tax bill of $19,000 ($5,000 penalty plus $14,000 income tax) on this less-than-happy event.
Here is the Tip:
Before your termination date, find a way to borrow $50,000 on a short-term basis to pay off the employee 401(k) loan. This will eliminate the tax penalty and income tax on the $50,000. Look to your bank, a line of credit on your home or a relative. The stakes are too high to give up at this point.
Form your self-employed entity. It could be as simple as getting a business license and opening a business bank account. You could be a sole proprietor, partner, or corporation (S-corporation or C-corporation).
Set up a solo 401(k) with your self-employed entity as the sponsor for the plan. Make sure the plan allows loans to employees. Transfer your 401(k) balance from your old plan to the new solo 401(k) plan. This is a tax-free transfer or rollover. Lastly, take a loan from the solo 401(k) plan of $50,000 and repay the short-term loan.
The Fine Print:
The goal of this strategy is to replace a loan in your old plan with a loan in your new plan while avoiding $19,000 in penalties and tax. However, you would have some costs as well. Plan on paying around $2,000 to have the solo 401(k) plan set up. You also need to consider the interest and costs (approximately $500) on the short-term loan. ($19,000 less costs of $2,500 = $16,500 / $50,000 = 33% savings).