How Do Taxes Work for 401(k) Loans?

When you take a 401(k) loan, you can generally avoid taxes by paying it back on time. If you don’t pay it back, your loan could be taxed as an early withdrawal.

This post is provided for general information only. Please confirm the details and circumstances of your unique situation with your tax accountant or other appropriate advisor before taking action.

Should you use a 401(k) loan or an early withdrawal?

If you need to take money out of your 401(k), you should carefully consider using a 401(k) loan instead of just withdrawing the money. There are several advantages and disadvantages of using a 401(k) loan compared to an early withdrawal.

Advantages of 401(k) LoansDisadvantages of 401(k) Loans
Avoid taxes and penalties on early withdrawals if pay back the loanNo tax deduction on repayments or interest (but you got a tax deduction when you made the original contribution)
Ability to put the money back in your 401(k) without using up future years’ contribution limitsLoans aren’t offered by all 401(k) plans
For homebuyers, your loan payment doesn’t count towards your debt-to-income ratioFor homebuyers, there is no penalty exception like there is for IRAs
You pay interest to your own retirement plan instead of a bank (minus any fees charged by your plan) Some plans (not all) don’t allow you to make new contributions until you pay back the loan
Your invested money can continue to growYou may have to repay the loan in full if you leave your job or it may count as an early withdrawal

401(k) Loan Taxes and Penalties

What taxes are there if you pay your 401(k) loan on time?

There are no taxes or penalties if you pay your 401(k) loan on time.

What taxes are there if you don’t pay your 401(k) loan on time?

If you miss payments and default on your loan, the remaining balance of the loan becomes an early distribution. You pay your ordinary income tax rate plus (if under age 59.5) a 10% early withdrawal penalty.

The distribution counts as taxable when you defaulted on the loan. It’s not when you originally took out the loan. The default occurs when you miss a payment or the quarter after you miss a payment depending on the terms of your 401(k) plan.

The tax and distribution is based on the remaining balance of the loan when you default. If you took out $10,000 and had already repaid $6,000, your taxable early distribution is $4,000.

What taxes are there if you leave your job before repaying your 401(k) loan?

Many plans require you to repay your 401(k) loan in full if you leave your job. Other plans allow you to continue making payments.

If your plan requires you to pay in full when leaving your job, you have until the due date of your tax return to pay off your loan. For example, if you leave your job in February 2022, you have until April 2023 to repay the loan since the distribution would count for 2022 taxes filed by April 15, 2023. If you need even more time to repay the loan, you can request an extension of time to file your tax return and get another six months.

If you can’t pay your loan in full, you owe taxes and penalties the same as for missing payments as described above.

Are there exceptions to the 10% penalty?

There are several exceptions to the 10% penalty if you used the money for one of the following purposes. Additional requirements often apply, so check with your tax advisor first.

  • You become disabled
  • Money paid as part of a divorce order
  • You have an IRS levy
  • You have a large unreimbursed medical expense
  • You leave your job during or after the year you turn 55

Unlike with IRAs, there are no penalty exceptions for educational expenses, buying a home, or paying for your health insurance while unemployed.

What tax form do you get if you default on your 401(k) loan?

If you default on your 401(k) loan, your plan provider will send you a Form 1099-R. You’ll pay any taxes and penalties on your Form 1040 tax return for that year.

What should you do if your 1099-R is wrong?

First, contact your plan provider to request a corrected 1099-R.

If they won’t change your 1099-R, file your tax return according to the correct numbers and attach an explanation. You may want to check with a tax professional to make sure your 1099-R is actually wrong.

Do you pay taxes twice when you repay a 401(k) loan?

No, you don’t pay taxes twice. Even though you repay the 401(k) loan with after-tax dollars, that’s your first time paying taxes.

  • Original contribution: Excluded from your taxable income / not taxable
  • Taking out the loan: Not taxable even though it gives you cash outside of your retirement account
  • Repaying the loan: You have to use money you paid taxes on because you never paid taxes on your loan money

Can you make loan repayments to an IRA or another 401(k)?

Loan payments generally need to be made to the original 401(k). Loans are specific to a 401(k) plan.

Can your employer pay your 401(k) loan?

You can have your employer pay a portion of your regular salary or bonuses towards your 401(k) loan. However, this is taxable income. Since the money is going towards your loan, it doesn’t count as a tax-deferred employer contribution.

What tax form do you use to show you repaid your 401(k) loan?

You don’t need to report a 401(k) loan or your repayments. The IRS generally doesn’t know about your 401(k) loan unless you default and your plan issues a 1099-R.

Keep detailed records of your loan and repayments, such as confirmation letters and account statements, in case of any problems.

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