Are 401(k) loans taxed?

By Daniel Kurt AAA
A:

Generally, any money you borrow from a 401(k) account is tax exempt. This feature is one of the reasons that - for critical short-term needs - such loans may be a better alternative to hardship withdrawals or high-interest forms of credit.
As long as you pay the loan back in a timely matter, the only tax consequence comes from the interest some plans require you pay (though the term "interest" is a bit misleading, as the funds go back into the participant's own account). Because you have to use after-tax dollars to pay the interest, the government gets to take a portion of it twice - you pay income tax on the amount again when you tap the account in retirement. However, 401(k) interest rates are typically modest - often around 5% - so the double taxation has a relatively small impact. It only takes on major significance when you're borrowing a lot of money and repaying it over several years.

When you can really feel a tax pinch is if you default on the loan. If you're younger than 59.5 years old, the outstanding loan balance is treated much like a hardship withdrawal - it's subject to a 10% early-withdrawal penalty and treated as regular income for tax purposes.

Let's say you 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'll have to hand 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.

For this reason, it's important to determine your ability to repay a 401(k) loan before proceeding. Most planners suggest keeping your nest egg intact unless the needs are pretty dire - for example, when you're no longer able to pay utility bills or groceries. Buying a new piece of stereo equipment isn't worth the risk.

However, if you absolutely need funds and are confident you can pay the loan back going forward, the minimal tax consequences and ability to pad your account with interest can make these loans a viable option.

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