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.
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 taking a hardship withdrawal. There are several advantages and disadvantages of using a 401(k) loan compared to an early withdrawal.
|Advantages of 401(k) Loans||Disadvantages of 401(k) Loans|
|Avoid taxes and penalties on early withdrawals if pay back the loan||No 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 limits||Loans aren’t offered by all 401(k) plans|
|For homebuyers, your loan payment doesn’t count towards your debt-to-income ratio||For 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 grow||You 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.