Are 401(k) loans taxed?
The great part of 401(k) loans are that you can access your pension money that you worked hard for, but do not pay a penalty for early withdrawal or taxes. The added benefit is that the interest you pay to use your own money (typically 4 to 5%) is earnings to your 401(k) plan :)
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.
A loan that you take from your 401(k) is not taxed at the time which you take the loan. If you pay the loan back as intended, there will be no taxes.
However, if you do not pay the loan back and distribute the remaining funds from the 401(k) account, you wil pay income taxes on the total amount withdrawn. This is also the case if you Rollover a 401(k) which has an outstanding loan.
Be aware, you may also be assessed a 10% early withdrawal penalty by the IRS unless you are over the age of 59 ½ or qualify for one of these exceptions.
Stephen Rischall, CRPC
Good morning this is a very tricky question. The loan from your 401k technically is not taxable, but it is. Let me explain. When you borrow from the 401k plan you get your check, deposit it in to your bank account and you then start to make payment on it. So far no taxes, however here is the catch, when you are paying your loan off, unlke 401k contirbutions, your loan payments do not come out pre-tax they come out AFTER TAX. However as soon as your loan payments hit your 401k plan they become pretax money and therefore when you take it out later in life (retirement) you will be taxed on that ammount again.
This is confusing so let me give you an example: You take out $10,000 as a loan, you are paying it off with after tax money and eventualy you pay it off. Now when you retire and you are taking that 10,000 distirbution out it will be taxed to you again.
So as you can see at the end of the day loans are double taxed. This is not to say that loan is a good or a bad option this is simple answering your question.
Feel free to reach out if you need clarification.
401(k) loans are not taxed if they are re-paid by the borrower. However, if the loan is not repaid when you leave your employer and roll the 401(k) into an IRA, the loan amount is considered a distribution and you will owe tax on it as well as a penalty if you are under 59 ½.