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 assets in the account are used for collateral. For plans that allow loans, the loans must be repaid, with interest, within a prescribed time frame.
- 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.
- A 401(k) loan can be better than another high-interest financing because the money borrowed is tax-exempt.
- If you default on the loan you will pay income taxes 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 alternative to hardship withdrawals or high-interest forms of credit. The reason is that any money borrowed from a 401(k) account is tax-exempt, as long as you pay back the loan on time.
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 the double taxation has a relatively small 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, President Trump signed a $2 trillion coronavirus emergency relief package. It doubles the amount of 401(k) money available as a loan to $100,000 and waives the 50% of balance limitation—and drops the early-withdrawal penalty if you default at younger than age 59½—but you'll need certification that you’ve been impacted by the COVID-19 pandemic.
As an example (under the traditional, non-coronavirus rules), 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. With the introduction of the CARES Act, you would now be able to borrow $100,000 of that $120,000 but only if you have been affected by the coronavirus pandemic.
Defaulting on a 401(k) Loan
The tax consequences are significant for borrowers who default on a 401(k) loan. Except in 2020 for the COVID-affected, 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 for 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.
Milestone Asset Management Group LLC, Avon, CT
When you borrow money from your 401(k) plan there are no immediate taxes involved. However, when you pay off your loan, unlike 401(k) contributions that are made pre-tax, the loan payments are after-tax.
As soon as your loan payments hit your 401(k) plan, they become pre-tax money and, therefore, when you take it out later in life (retirement) you will be taxed on that amount again.
For example, you take out $10,000 as a loan, then start to pay it back into the plan with after-tax money. When you retire and withdraw that $10,000, it will be taxed again so the same pool of money is actually double taxed.