While borrowing from your 401(k) account can hurt your long-term retirement planning, that’s not the only consideration. There are also tax implications if you’re not able to repay the funds in a timely manner. Here’s what you need to know before taking out a 401(k) loan, and how it could impact your retirement nest egg.

Are 401(k) Loans Taxed?

When it comes to borrowing from a 401(k), understanding the tax implications is important. Unlike direct withdrawals, which typically incur taxes when they happen, 401(k) loans are designed to be tax-neutral as long as certain conditions are met.

The IRS considers 401(k) loans a form of self-borrowing, thereby avoiding the taxable distribution category. However, you must meet certain requirements, such as repaying the loan by a certain time, in order to maintain your ability to avoid that tax.

The loan must be repaid within a five-year term, except when used for purchasing a primary residence, which may permit a longer repayment period. Additionally, the loan amount is capped at the lesser of $50,000 or 50% of the vested account balance. Repayments, including both principal and interest, are required at least quarterly to prevent the loan from being considered a taxable distribution. Failure to comply can lead to severe tax repercussions and penalties.

How a 401(k) Loan Works

A 401(k) loan begins when you make a loan request to the plan administrator, who evaluates your eligibility as a borrower based on the plan’s standards and IRS regulations.

Once you get approval, the loan amount is deducted from the 401(k) account, thereby reducing the amount you will have available for your retirement investment. You must must then adhere to a repayment plan in order to avoid any tax consequences.

Plan-specific interest rates for 401(k) loans are generally competitive, often being slightly above the prime rate. Diligent adherence to the repayment terms is key to maintaining the non-taxable advantage of the loan and preventing default.

You may want to get advice from a financial advisor or plan administrator before taking out the loan. This could help you understand whether this is the best option for your specific circumstances, or if there are other alternatives that could serve you better.

How a 401(k) Loan Impacts Your Tax Liability

A couple comparing the benefits and drawbacks of taking a 401(k) loan.

A 401(k) loan does not increase your immediate tax liability, as it is not considered 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.

When assessing the true cost of a 401(k) loan, you should consider long-term implications, such as how much you will lose in compound interest for the amount borrowed.

When you borrow from a 401(k), you withdraw funds from your investment balance, which can lead to missed capital gains. For example, borrowing $20,000 means that you will have $20,000 less earning earning compound interest in your retirement account. Also, you generally cannot make any new contributions to the 401(k) account while the loan is outstanding.

Other Potential Risks of Taking Out a 401(k) Loan

In addition to losing potential money on your retirement investments, you should also consider the risks associated with a loan default.

One common reason for falling behind on your loan payments could be losing your job. And if you can’t pay your loan back, the remaining outstanding balance will be treated as a taxable distribution, which is subject to early withdrawal penalties.

Here are three things that could happen with a loan default:

  • Taxable distribution: As we already mentioned, a loan default will turn the balance into a taxable distribution. And, if you’re under age 59 1/2, you may also get hit with a 10% early withdrawal penalty.
  • Financial stress: 401(k) loan repayments are typically made as payroll deductions. These begin in the pay period immediately following the loan. So keeping up with this repayment schedule could mean directing funds that would have paid for other financial needs. And this can possibly lead to more difficulties.
  • Creditworthiness impact: While not all 401(k) loan defaults may get reported to credit agencies, it’s a possibility that can affect your credit score and borrowing ability in the future.

Understanding a 401(k) Loan vs. Taking a Withdrawal

Choosing between a 401(k) loan and a withdrawal involves evaluating the tax consequences and penalties. Withdrawals lead to immediate taxation and, if made before age 59½, could also incur a 10% penalty. In contrast, a 401(k) loan that is repaid on time avoids upfront taxes and penalties, which could provide a temporary resource without the immediate tax drawbacks of a withdrawal.

When choosing between a 401(k) loan and a withdrawal, it could be useful to have a reference list outlining the benefits and drawbacks for a quick comparison:

  • No immediate taxes or penalties if repaid on schedule.
  • Repayments made with after-tax dollars.
  • Potential to impact retirement savings growth.
  • Taxable event with immediate tax consequences.
  • If under age 59½, a 10% penalty applies.
  • No repayment obligation, but reduces retirement savings.

The advantages of a 401(k) loan can include borrowing from one’s own savings, often at a lower interest rate than commercial loans, with the interest paid back into the your retirement account. However, loans typically must be repaid in full if the borrower leaves their employer for any reason, which can be burdensome.

Withdrawals, on the other hand, provide immediate access to funds without the obligation of repayment, they permanently reduce the retirement nest egg and forfeit the tax-advantaged growth opportunities that make a 401(k) plan a popular retirement savings tool.

Additionally, you should also consider the loss of potential gains for both loans and withdrawals. Ultimately, your specific circumstances will determine which option is best for your finances.

Bottom Line

A couple happy after repaying their 401(k) loan.

401(k) loans offer an alternative to direct withdrawals by allowing individuals to borrow against their retirement savings without immediate tax liabilities. This benefit is only guaranteed as long as you are able to comply with the repayment conditions. Failing to do so will turn your loan into a taxable event. And, if you’re under age 59 1/2, you could also face a withdrawal penalty. As a borrower, you must carefully weigh the benefits and drawbacks, including how much money you could lose in compound interest for the borrowed amount.

Tips for Saving for Retirement

  • A financial advisor who is experienced in retirement planning can help you create a plan for your specific needs. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • When you’re saving for your golden years you may want to consider using a free retirement calculator, which can help you see if you’re saving enough to stay on track for your goals.

Photo credit: ©iStock.com/insta_photos, ©iStock.com/RgStudio, ©iStock.com/shapecharge

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