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Question:


Are 401(k) loans taxed? If so, how much?
-JustWondering


Answer:


A loan taken from your 401(k), something that’s available in many employers’ plans, is not taxable per se. After all, what’s there to tax? You’re borrowing money from the plan, not withdrawing it for good. Internal Revenue Service rules allow participants to borrow up to $50,000 or half the value of their accounts, whichever is less. The money must be paid back within five years, but this can be extended if the loan is to be used as a down payment on a home. A reasonable interest rate must be charged, but remember that you’re effectively borrowing from yourself, so the interest gets credited to your account along with principal as you repay the cash.

So a 401(k) loan has no tax consequences. If you fail to pay it back, however, that does have consequences. The balance on any loan that goes into default because the borrower has skipped repayments is considered a distribution, and the plan administrator will be required to report it to the IRS. Also, if you leave your job, any outstanding loan balance must be repaid fairly quickly, usually in 30 to 90 days. The amount of a 401(k) loan that’s unpaid for either of these reasons will be considered ordinary income and taxed as such, just as any distribution would. So if you’re delinquent on $20,000, say, and your marginal federal tax rate is 25 percent, you’ll be on the hook for $5,000.

That’s just for starters. The IRS will tack a 10 percent penalty onto the distribution if you’re under 59 and a half years old, and you’ll owe state income tax if there’s one where you live. It’s also possible that the interest that would have accrued on the outstanding balance if you had paid the loan back as scheduled will be added to the taxable amount. The prospect of an unplanned tax liability is one reason that 401(k) loans are typically considered a bad idea. Another is that, even if you do repay it, the money that you borrow isn’t building up investment gains for your retirement while it’s not in your account. You’d probably do better, therefore, to seek another source for the funds you need, but if one isn’t available, be very sure that you can pay back a 401(k) loan before you proceed.

-Conrad de Aenlle



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