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.
What Is a 401(k) Loan?
Some employers allow participants to borrow against their 401(k) retirement savings plans. Borrowing from your own 401(k) will not affect your credit and does not require a credit check. For plans that allow loans, the loans must be repaid with interest within a prescribed time frame.
If the borrower defaults on a 401(k) loan, they are typically subject to a 10% early withdrawal penalty on the outstanding balance.
Tax Consequences of 401(k) Loans
As long as the loan is paid back in a timely matter, 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 pay the interest. Therefore, the government takes 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—often around 5%—so the double taxation has a relatively small impact. It is only significant when the amount borrowed is large and repaid over several years.
- Some employers allow participants to borrow against their 401(k) retirement savings plan; this is called a 401(k) loan.
- 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.
- Depending on the plan, a borrower may not be able to make contributions if they have a loan outstanding.
The Amount That Can Be Borrowed
Each plan has its own limits for loans. However, the IRS allows you to borrow $50,000 or 50% of the total amount saved, whichever less. An exception is that if the vested balance is $10,000 or less, you can borrow up to $10,000.
As an example, if your 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 the 401(k) Loan
If the borrower defaults on a 401(k) loan, the tax consequences will be significant. For borrowers younger than 59 ½ years old, the outstanding loan balance is treated as a hardship withdrawal—it is 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 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.
The Risks Involved with a 401(k) Loan
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.
When to Opt for a 401(k) Loan
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 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.
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.