Dear New Frugal You,

My daughter got laid off from her job. She had a loan on her 401(k) and was unable to pay the balance off immediately. I'm pretty sure that she owes taxes on that unpaid balance, but neither of us knows how she is supposed to go about doing that. She didn't know the exact amount of the unpaid balance and doesn't know how to go about reporting it. Is she supposed to receive something from the 401(k) company or the IRS? For those of us who know nothing about such things, can you tell us how to go about finding out where and how to get this information and how does she go about paying the taxes?

-Lois

Dear Lois,

Sorry to hear about your daughter's job. You're absolutely right. She does owe taxes and maybe even a penalty on the unpaid balance. Her 401(k) loan has taken a bad situation and made it worse.

For help on this question I turned to Stacy Johnson. He's a CPA with 30 years experience and also publisher of MoneyTalkNews.com. According to Mr. Johnson, "She should have gotten a Form 1099-R from the company showing the amount of the loan as taxable income. If she didn't, she should call them and ask where it is." The contact information should be on her 401(k) statements. 

As to how much she'll owe, that depends on her age and taxable income bracket. "She will have to compute the penalty, if applicable, when she prepares her income tax return. If she uses tax preparation software, it should do it for her."

The penalty is for an early withdrawal. That's a distribution made before you reach age 59-1/2. There are some exceptions, including hardship, college expenses and buying a first home. Assuming that your daughter is too young for a normal distribution, perhaps she can qualify for one of the exceptions (hardship? college?).

The amount of the penalty is 10% of the withdrawal amount. In this case that would be the amount of unpaid loan.

In addition to that, your daughter will need to add the unpaid loan amount to her taxable income for the year. One possible piece of good news is that she may be in a lower tax bracket this year due to the layoff. A small benefit, but let's take all the bennies we can get.

Once she has the 1099-R she should be able to complete the task on her 1040.

The IRS has publication 575 that covers pension and annuity income. It explains some of the details, although I'd be the last to say that following 1040 instructions are easy! Using tax preparation software or an accountant to prepare your daughter's taxes might be a good idea if she runs into trouble.

The rest of us can learn from your daughter's situation. A 401(k) loan is often thought of as a relatively painless way to borrow money. After all, we're borrowing from ourselves. And any interest that we pay is going back into our account.

But there are some serious drawbacks. One of the biggest is the one that your daughter fell victim to: Any 401(k) loan must be repaid in full if you leave your employer, whether the departure was voluntary or involuntary.

That can be significant. Suppose you have a loan and you're offered a better job. Unless you can afford to repay the whole loan, accepting the offer could trigger a tax problem. You could be trapped in your job until the loan is repaid.

Or a situation like your daughter's could arise. You didn't say why she borrowed the money. For illustration, let's assume that it was to buy a car. At the time, the decision seemed simple: Pay interest to a stranger or pay it to myself.

But had she borrowed from a bank, her loan wouldn't have suddenly become due when she lost her job.

Some might argue that's a good thing. A bank loan would still require monthly payments even though she's unemployed. But if she thought it wise, she always could have taken an early 401(k) distribution, at her discretion, and not have it forced on her.

Hope that your daughter finds a great new job quickly and that figuring her taxes isn't too complicated!

See related: Facing a layoff? Take control to minimize the damage, 1099C Surprise IRS tax surprise follows forgiven debt, Is 401(k) at risk if my company goes bankrupt?