If you have a 401(k) account and need cash, it may be tempting to tap your retirement for a loan. Legally, you can borrow up to $50,000 or half the balance of your account (whichever is less). You will also be paying yourself back, so any interest will go to you and not a lender, and the interest rate is lower than many other types of loans, generally around 5%.
At first glance, it may seem as if there is no downside to borrowing from your 401(k), but you may be wondering, does a 401(k) loan get taxed?
In short, if you repay your 401(k) loan on time, you will not be taxed. However, there is a tax consideration to keep in mind. When you make payments on your 401(k) loan, you will be making these payments with post-tax funds. Then, when you withdraw money after retirement, you will be taxed a second time. However, since the interest rate is relatively low, the tax will be rather insignificant.
There are some negative aspects to borrowing from your 401(k), though. First, if you leave your job or are fired before repaying the loan, you must repay the entire balance within 60 days. If you do not, the loan will be considered an early distribution, and you will have to pay a 10% early withdrawal penalty and taxes if you are younger than 59 1/2. This means that if you borrow $10,000 and have a tax rate of 15%, you will need to pay a $1,000 penalty and $1,500 in income tax. Because the risks are so high, it is important to determine whether you can realistically repay your 401(k) loan.
Secondly, while you are repaying your loan, your employer may not allow you to make your normal pretax contributions. If your employer has this policy, you will not be able to increase your 401(k) balance, and your income taxes may increase since you are not making any pretax contributions.
Even with these potential risks, there are some benefits to borrowing against your 401(k). For instance, if you are making payments on a high-interest loan, it may be more cost efficient to pay these debts with funds from a 401(k) loan.
If you are facing dire financial circumstances, you may want to consider these alternatives before borrowing against your 401(k).
- Consider a home equity loan, as the interest paid on this loan is tax-deductible.
- If you have a challenging financial situation, you may just want to take an early withdrawal from your 401(k). If you are having an extreme hardship, such as an unexpected medical expense, you may be able to avoid the 10% penalty.
- If you have an IRA, you can look into a 72(t) withdrawal, which allows you to avoid the 10% early withdrawal penalty. With this sort of withdrawal, you take a series of distributions in equal periodic payments. The payments must last for a minimum of 5 years or until you reach age 59 1/2, whichever comes later. The withdrawals will still be taxable, but you won’t have to pay a penalty.
Before you decide whether to borrow funds from your 401(k), you must weight the costs of decreased savings opportunities and the chance of penalties and taxes. You should also look into some of the other options available. After weighing all the pros and cons, if you still decide to borrow from your 401(k), make sure you have a realistic plan for paying the debt back quickly.