Does Your Vested Balance Include Plan Loans?
An outstanding retirement loan is considered part of your account's total value. Learn how this principle impacts the calculation of your vested balance.
Taking a loan from a 401(k) plan often creates confusion about its impact on the account’s value, specifically the vested balance. This calculation is important for understanding the true value of your retirement assets, especially when considering a job change. The relationship between a loan and your vested amount involves a few details about how retirement plans operate.
Understanding Your Vested Balance
Your vested balance is the portion of your retirement account you own outright and can take when you leave a job. Contributions you make from your paycheck are always 100% yours. Vesting rules apply specifically to contributions made by your employer, such as matching contributions or profit sharing.
Employers use vesting schedules to encourage employee longevity. These schedules determine when you gain full ownership of company contributions. The two most common types are cliff and graded vesting. Under a three-year cliff vesting schedule, you gain 100% ownership of employer funds after three years of service but own 0% before that.
A graded schedule allows you to gain ownership incrementally. A common six-year graded schedule might give you 20% ownership after two years of service, increasing by 20% each year until you are fully vested after six years. The specific schedule is detailed in your plan’s Summary Plan Description.
How a Plan Loan Affects Your Account
When you take a loan from your 401(k), you are borrowing from yourself, and the outstanding loan balance is considered an asset of your account. It is not a withdrawal if you adhere to repayment terms. Your vested balance is calculated based on your total account value, which includes both your investments and the outstanding loan. This ensures the loan is accounted for as part of your retirement assets subject to vesting.
To illustrate, assume your total account value is $50,000. This consists of a $10,000 loan and $40,000 in investments, and is made up of $30,000 from your contributions and $20,000 from your employer’s match.
Your own contributions are always 100% vested, so you own that $30,000. The vesting percentage applies only to the $20,000 employer portion. At 60% vested, you would own $12,000 of the employer match ($20,000 x 60%). Your total vested balance would be $42,000 ($30,000 from your contributions + $12,000 from the employer match).
Loan Repayment and Default Implications
The status of your plan loan can change if you leave your job, as most plans require you to repay the balance shortly after employment ends. The Tax Cuts and Jobs Act of 2017 extended the repayment window, giving you until the tax filing deadline of the following year to repay the loan and avoid default. Failure to meet this deadline has financial consequences.
If you cannot repay the loan in time, it is considered a “deemed distribution” or loan offset. The outstanding balance is then treated as a taxable withdrawal from your account. This amount is reported to the IRS as ordinary income, and if you are under age 59½, it is also subject to an additional 10% early withdrawal penalty.
A defaulted loan reduces your retirement savings by the outstanding amount. For instance, if you default on a $10,000 loan, that amount is removed from your account balance and becomes taxable income. This action does not affect your credit score, as plan loan defaults are not reported to credit bureaus. However, the tax liability and penalty can create a significant and unexpected financial burden.