A 401(k) loan allows you to borrow money from your 401(k) retirement savings plan. Understanding 401 k and taxes is crucial. As this option, while useful in certain situations, comes with specific rules and potential consequences. Here, we explain what a 401(k) loan is, how it works, and when it might be a good choice.
Read: Tax 101: Basics You Need to Understand
What Is a 401(k) Loan?
A 401(k) loan is a loan taken against your 401(k) retirement account. It doesn’t require a credit check, and it won’t impact your credit score. Since the loan is secured by the assets in your account. However, you must repay the loan with interest within a specified period.
How a 401(k) Loan Works
Borrowing from your 401(k) can be a preferable alternative to a hardship withdrawal or a high-interest bank loan for short-term financial needs. The money you borrow is tax-exempt as long as you repay it on time. Additionally, the interest you pay goes back into your own account rather than to a bank.
You don’t need to report a 401(k) loan on your tax return. If repaid on schedule, the only tax-related issue is that you’ll use after-tax dollars to repay the loan. This includes the interest. This means you’ll be taxed on the amount again when you withdraw it in retirement, leading to some double taxation. However, because 401(k) interest rates are typically low, the impact is usually minimal unless you’re borrowing a large amount over many years.
The IRS permits loans of up to $50,000 or 50% of your vested balance, whichever is less. If your vested balance is below $10,000, you may borrow up to $10,000, provided your account balance is at least that amount. Each 401(k) plan has its own loan policies and may not offer loans at all. So make sure to check with your employer for details.
For example, if your vested balance is $15,000, you can borrow up to $10,000 because 50% of $15,000 is $7,500. Conversely, if your balance is $120,000, the maximum you can borrow is $50,000.
Risks of Defaulting on a 401(k) Loan
Failing to repay a 401(k) loan can result in significant tax penalties. If you are under 59½ years old, defaulting means you’ll incur a 10% early withdrawal penalty in addition to owing income tax on the outstanding loan balance.
For instance, if you default on a $10,000 loan with an effective tax rate of 15%, you would owe $1,000 for the early withdrawal penalty and $1,500 in income tax by the time you file your annual tax return. Consequently, your $10,000 loan reduces to $7,500 after taxes and penalties.
Other Risks of a 401(k) Loan
Some 401(k) plans restrict contributions while a loan is outstanding. If it takes five years to repay the loan, you will not contribute to your retirement savings during this period, missing out on tax advantages and potential employer matching contributions.
401(k) Loan vs. Withdrawal
Before opting for a 401(k) loan, assess your ability to repay it. Financial planners often advise against tapping into your retirement funds unless necessary for essential expenses like rent, mortgage, utilities, or groceries.
If you are confident you can repay the loan, the minimal tax consequences and the fact that you are paying interest to yourself can make a 401(k) loan a viable option for immediate financial needs.
In summary, a 401(k) loan may provide a solution for immediate financial needs, but it is crucial to comprehend the repayment terms and associated risks. Before proceeding, evaluate your financial position thoroughly and consider all available options related to 401 k and taxes.