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 remaining assets in✤ the account are used for collate🐬ral. For plans that allow loans, the loan must be repaid, with interest, within a prescribed time frame.

How a 401(k) Loan Works

For critical short-term needs, borrowing from a 401(k) account can be a better choice than a 澳洲幸运5官方开奖结果体彩网:hardship withdrawal, which is allowed in certain circumstances, or a high-interest bank loan. Any money borrowed from a 401(k) account is 澳洲幸运5官方开奖结果体彩网:tax-exempt, as long as you pay back the loan on time. And you're paying the interest to you🐷rself, not to a bank.

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 澳洲幸运5官方开奖结果体彩网:after-tax dollars to repay the loan, including interest. This means the government taxes a portion of it twice—澳洲幸运5官方开奖结果体彩网: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 澳洲幸运5官方开奖结果体彩网:double taxation has a negligible 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.

As an example, if your vested balance is $15,000, you can borrow $10,000 because 50% is only $7,500. However, if youꦏr balance is $120,000, the maximum you can borrow is $50,000. 

Defaulting on a 401(k) Loan

The tax consequences are significant for borrowers who default on a 401(k) loan. Those younger than 59½ years old will be subject to a 10% 澳洲幸运5官方开奖结果体彩网: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 澳洲幸运5官方开奖结果体彩网:effective tax rate of 15%. By the time you file your annual tax return, you will owe the go𒁃vernment $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 $𝐆7,500.

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, 澳🅘洲幸运ౠ5官方开奖结果体彩网:you will save nothing to your 401(k). That also means that will not benefit fr🐻om the tax advantages of making payments to your retirement account.

You will also miss out on any 澳洲幸运5官方开奖结果体彩网:matching contributions that your employer might provide while you are paying off the 🧔loaꦛn.

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 lꦓonger pay your rent or mortgage, utility bills, or groceries.

In short, if you need funds and are confiden🙈t you can pa꧃y the loan back, the minimal tax consequences and ability to pad your account with interest can make these loans a viable option.