What Happens If There Is a Loan Against My Spouse’s 401(k)?

Divorcing couples are often faced with dividing the balance of a 401(k). Suppose Joan has a 401(k) with a gross balance of $100,000.00. She and her husband, John, negotiate that John will receive 50% of the 401(k).

Fair enough. But what happens if John discovers that Joan has borrowed money from her 401(k)? Say, a loan of $10,000.00?

This is more common than people realize. Many 401(k) plans allow participants to take loans from their accounts. The loan is generally repaid through payroll deductions, with interest going back into the participant’s retirement account. But does the loan change the value of the 50% Joan promised to John? Who pays the loan?

Before we discuss solutions, let’s be sure we understand the problem.

The Problem

The problem is essentially one of “order of operations,” just like we learned in elementary school. Put another way, the question is whether we subtract the loan before or after dividing the account.

For purposes of this example, let us assume that Joan’s $100,000.00 gross balance includes the $10,000.00 loan. In other words, there is $90,000.00 actually invested in the account, and Joan owes the plan another $10,000.00.

There are two ways the parties might treat this loan.

First, they might decide that the loan should reduce the balance before the account is divided. In that case, the $10,000.00 loan is subtracted from the $100,000.00 gross balance first:

$100,000.00 – $10,000.00 = $90,000.00.

Then the parties divide the remaining balance:

$90,000.00 ÷ 2 = $45,000.00.

John receives $45,000.00, and Joan receives $45,000.00. Joan remains responsible for repaying the $10,000.00 loan.

Second, the parties might decide that the loan should not reduce John’s share. In that case, they divide the full $100,000.00 balance first:

$100,000.00 ÷ 2 = $50,000.00.

John receives $50,000.00. Joan receives the remaining $50,000.00, but she still owes the $10,000.00 loan. In practical terms, Joan ends up with $40,000.00 in net retirement value after accounting for the loan.

In both examples, Joan still has to repay the loan. The difference is whether John shares in the economic effect of the loan.

Which scenario is better? Obviously, the first scenario is better for Joan; the second scenario is better for John.

The Solution

The first lesson is to make sure that you determine whether there are any loans against any 401(k)s.

Do not rely only on the account’s overall balance or just the assurances of your soon-to-be former spouse. Through the discovery process, you can request the most recent account statement and confirm whether there is an outstanding loan. It may also be useful to obtain information about the loan itself, including the original loan amount, the remaining balance, and the repayment schedule.

The second lesson is to decide clearly how the loan will be treated. Will it reduce the balance before the account is divided? Or will the participant spouse bear the loan after the account is divided? There are many reasons why you might want to include the loan or exclude it. For example, if the loan was used for a joint marital expense, such as home repairs or family bills, you may decide it should be shared and therefore reduce the balance before division. On the other hand, if the loan was taken after separation or used for one spouse’s individual benefit, you may decide it should not affect the other spouse’s share. That is something you should discuss with your attorney.

The third lesson is to put that decision in writing.

It is not enough for an agreement simply to say that John will receive “50% of Joan’s 401(k).” The agreement should clarify whether that percentage is calculated before or after an outstanding loan is considered. It should also address whether either party may take new loans or withdrawals before the QDRO is completed.

Finally, remember that the retirement plan itself has rules. Some plans may have particular procedures for handling loans when a QDRO is processed. The QDRO drafter must understand not only what the parties agreed to, but also what the plan can actually do.

A $10,000.00 loan can create a $5,000.00 difference in what one spouse receives. It is worth identifying and resolving before the parties sign an MSA and before the QDRO is drafted.

If you have questions about dividing a 401(k), an outstanding retirement-plan loan, or any other QDRO issue, the attorneys at Weinberg & Schwartz, LLC are happy to help.