What Is a 401(k) Loan?
A 401(k) loan is money borrowed against a 401(k) retirement savings plan. Borrowing from your own 401(k) will not affect your credit and does not require a credit check, as the remaining assets in the account are used for collateral. For plans that allow loans, the loan must be repaid, with interest, within a prescribed time frame.
Key Takeaways
- Some employers allow participants to borrow against their 401(k) account, but there are limits on how much.
- A 401(k) loan will not affect the borrower's credit and does not require a credit check.
- If you default on the loan you will pay income taxes on the money withdrawn and may also be subject to an early withdrawal penalty.
- Depending on the plan, a borrower may not be able to make contributions if they have a loan outstanding.
How a 401(k) Loan Works
For critical short-term needs, borrowing from a 401(k) account can be a better choice than a hardship withdrawal, which is allowed in certain circ*mstances, or a high-interest bank loan. Any money borrowed from a 401(k) account is tax-exempt, as long as you pay back the loan on time. And you're paying the interest to yourself, not to a bank.
You do not have to claim a 401(k) loan on your tax return. As long as the loan is paid back in a timely manner, the interest attached to certain plans is the only tax consequence. The term "interest" is a bit misleading because the funds go back into the participant's own account.
The borrower must use after-tax dollars to repay the loan, including interest. This means the government taxes a portion of it twice—income tax is paid on the amount again when the borrower taps the account in retirement. However, 401(k) interest rates are typically modest so double taxation has a negligible impact. It is only significant when the amount borrowed is large and is repaid over several years.
The IRS allows loans of $50,000 or 50% of your vested balance, whichever is less. An exception is when the vested balance is less than $10,000. In that case, you may be allowed to borrow as much as $10,000, provided the vested account value is at least $10,000. Each plan has its own limits for loans and is not required to offer them at all, so check with your employer for specifics.
On March 27, 2020, President Trump signed a $2 trillion emergency relief package. It doubled the amount of 401(k) money available to $100,000 and waived the 50% of balance limitation for loans made from March 27 to September 22, 2020. The Act also delayed the due date up to one year for outstanding loan repayments due from March 27 to Dec. 31, 2020.
As an example, if your vested balance is $15,000, you can borrow $10,000 because 50% is only $7,500. However, if your balance is $120,000, the maximum you can borrow is $50,000.
Defaulting on a 401(k) Loan
The tax consequences are significant for borrowers who default on a 401(k) loan. Those younger than 59½ years old will be subject to a 10% early withdrawal penalty in addition to paying income taxes on the outstanding balance.
Let's say you are younger than 59½, default on a loan with a $10,000 outstanding balance, and have an effective tax rate of 15%. By the time you file your annual tax return, you will owe the government $1,000 for the early withdrawal penalty and another $1,500 in income tax (which would otherwise be deferred until retirement). Within one year, that $10,000 is down to $7,500.
401(k) Loan Risks
Some plans do not allow participants to make plan contributions if they have a loan outstanding. If you take five years to repay the loan, you will save nothing to your 401(k). That also means that will not benefit from the tax advantages of making payments to your retirement account.
You will also miss out on any matching contributions that your employer might provide while you are paying off the loan.
401(k) Loan vs. Withdrawal
It is important to determine your ability to repay a 401(k) loan before proceeding. Most planners advise keeping your nest egg intact unless, for example, you can no longer pay your rent or mortgage, utility bills, or groceries.
In short, if you need funds and are confident you can pay the loan back, the minimal tax consequences and ability to pad your account with interest can make these loans a viable option.
FAQs
Any money borrowed from a 401(k) account is tax-exempt, as long as you pay back the loan on time. And you're paying the interest to yourself, not to a bank. You do not have to claim a 401(k) loan on your tax return.
Will I get taxed if I take a loan from my 401k? ›
Pros: Unlike 401(k) withdrawals, you don't have to pay taxes and penalties when you take a 401(k) loan. Plus, the interest you pay on the loan goes back into your retirement plan account.
How do I avoid 20% tax on my 401k withdrawal? ›
Can you avoid taxes on 401(k) withdrawals?
- Contribute to a Roth 401(k). If your employer offers a Roth 401(k) option, you can contribute after-tax money to it. ...
- Convert to a Roth IRA. ...
- Delay withdrawals. ...
- Use tax credits and deductions. ...
- Manage withdrawals strategically.
For a 401(k) loan, any interest charged on the outstanding loan balance is repaid by the participant into the participant's own 401(k) account; technically, this is a transfer from one of your pockets to another, not a borrowing expense or loss.
Why are 401k loans double taxed? ›
That $1K of interest is from your after-tax funds, and it gets added to your 401k balance, so you pay tax on it again when you withdraw the money in retirement.
Is it a good idea to take a loan from your 401k? ›
If you're disciplined, responsible, and can manage to pay back a 401(k) loan on time, great—a loan is better than a withdrawal, which will be subject to taxes and most likely a 10 percent penalty. But if you're not—or if life somehow gets in the way of your ability to repay—it can be very costly.
Do 401k loan repayments reduce taxable income? ›
No tax deductions or withholdings are made when the loan is taken out. However, it's crucial to understand that loan repayments are made with after-tax dollars and are not tax deductible, which contrasts with pre-tax contributions that can lower taxable income.
What is the best tax strategy for 401k withdrawal? ›
401(k) Rollover
The easiest way to borrow from your 401(k) without owing any taxes is to roll over the funds into a new retirement account. You may do this when, for instance, you leave a job and are moving funds from your former employer's 401(k) plan into one sponsored by your new employer.
Do you get taxed twice on a 401k withdrawal? ›
Do you pay taxes twice on 401(k) withdrawals? We see this question on occasion and understand why it may seem this way. But, no, you don't pay income tax twice on 401(k) withdrawals. With the 20% withholding on your distribution, you're essentially paying part of your taxes upfront.
How much income tax will I pay for 401k withdrawal? ›
As you pull money out, you'll owe income taxes on the funds. Some 401(k) plans will automatically withhold 20% or so of your account to pay for taxes.
You may also want to consider accelerating your repayment plan to get your 401(k) refunded as quickly as you can. Unlike some loans, there's no penalty for early repayment. Plus, the sooner the money is back in your account, the sooner it can start earning for you again.
Is it smart to borrow from 401k to pay off debt? ›
After other borrowing options are ruled out, a 401(k) loan might be an acceptable choice for paying off high-interest debt or covering a necessary expense. But you'll need a disciplined financial plan to repay it on time and avoid penalties.
Does a 401k loan affect credit? ›
Unlike other loans, 401(k) loans generally don't require a credit check and do not affect a borrower's credit scores. You'll typically be required to repay what you've borrowed, plus interest, within five years. Most 401(k) plans allow you to borrow up to 50% of your vested account balance, but no more than $50,000.
How much tax do I pay if I borrow from my 401k? ›
An advantage of a 401(k) loan over a withdrawal is you don't pay ordinary income taxes or face potential additional taxes on the borrowed amount. You must repay the loan along with interest, per the loan terms; but on the bright side, repayments replenish your plan account — you're essentially repaying yourself.
Do you have to report a 401k loan on your taxes? ›
Loans are not taxable distributions unless they fail to satisfy the plan loan rules of the regulations with respect to amount, duration and repayment terms, as described above. In addition, a loan that is not paid back according to the repayment terms is treated as a distribution from the plan and is taxable as such.
What is the penalty for defaulting on a 401k loan? ›
If you cannot repay the loan, you'll owe taxes, interest, and (for those under 59 1/2) a 10% penalty on the unpaid balance. No taxes or penalty on the loan amount, unless you default. Although you repay yourself with interest, you miss out on market returns on the borrowed amount, which could be higher.
Should I borrow from my 401k to pay off debt? ›
After other borrowing options are ruled out, a 401(k) loan might be an acceptable choice for paying off high-interest debt or covering a necessary expense. But you'll need a disciplined financial plan to repay it on time and avoid penalties.
Do you have to pay taxes if you take money out of 401k? ›
How does a 401(k) withdrawal affect your tax return? Once you start withdrawing from your traditional 401(k), your withdrawals are usually taxed as ordinary taxable income. That said, you'll report the taxable part of your distribution directly on your Form 1040 for any tax year that you make a distribution.
Will I get a 1099 R if I took a loan from my 401k? ›
If you have a 401(k) plan loan and are making timely payments on the loan, you will not receive a 1099-R from Ascensus. However, if payments are not made on time or you left your employer and the loan had not been repaid in full when you separated your employment, the loan will default.
Does taking a loan from a 401k affect credit score? ›
Unlike other loans, 401(k) loans generally don't require a credit check and do not affect a borrower's credit scores. You'll typically be required to repay what you've borrowed, plus interest, within five years. Most 401(k) plans allow you to borrow up to 50% of your vested account balance, but no more than $50,000.
