401(k) Loans

Do you pay taxes on 401k loan?

When you take a 401(k) loan, you could be wondering if you will pay taxes on the amount borrowed. Find out if and when to pay taxes on a 401(k) loan.

3 min read

If you need money to cover an unexpected expense, you could consider borrowing from your 401(k) - if your 401(k) plan approves it. A 401(k) loan allows retirement savers to borrow against their retirement savings, with the intent of paying back over a defined period. Although you are essentially borrowing from yourself, you will still pay interest on the loan back to your 401(k) account. You will have up to five years to repay the loan fully unless you are borrowing to buy your principal residence, where the loan term could be longer than five years.  

You don’t pay taxes on 401(k) loans as long as you pay the entire loan on time. However, the interest on the 401(k) loan is paid with after-tax dollars, but the impact of the income tax will be negligible since the interest component is a modest amount. If you default on your 401(k) loan obligations, the outstanding amount will be considered a withdrawal for tax purposes, and you will owe income taxes and a potential penalty if you are below 59 ½. 

How 401(k) Loan Works

If you need short-term funds and you cannot get them from any other source, borrowing against your retirement savings is a better alternative than a hardship withdrawal. A 401(k) loan is tax-exempt, and you can borrow the lesser of 50% of your 401(k) balance or $50,000. However, each plan has its limits, and your plan sponsor may offer a lower limit than what is allowed by the IRS. Since you are borrowing against your savings, the interest you pay also goes back to your 401(k) account.

When you take a 401(k) loan, you get similar loan terms as you would with a conventional loan. The 401(k) plan sets a repayment plan for the loan depending on the amount borrowed and the interest rate charged. Once you get approved for a 401(k) loan, you will have up to 5 years to pay back the loan. However, if you quit or are fired from your job, you will have until the tax due date to pay off the unpaid loan amount. You can also decide to voluntarily default on the 401(k) loan if you are unable to keep up with the loan repayments, but be ready to face the stiff consequences of 401(k) default.

Default on a 401k loan

If you are unable to pay off the outstanding 401(k) loan within the required loan term, the unpaid loan amount will be treated as an income for tax purposes. The outstanding amount will be taxed at your effective tax bracket rate, and an additional 10% penalty if you are below 59 ½.   

For example, assume that John is age 57 and he has a 401(k) loan with an outstanding balance of $10,000. John has missed out on multiple payments, and his loan is now considered to be in default. If John is in the 22% tax bracket, he will owe $2,200 in income taxes when filing the annual tax return. Also, since John is below 59 ½, he will owe $1,000 in early withdrawal penalties. In total, John will owe the IRS $3,300 in taxes from his unpaid 401(k) loan of $10,000. 

Do You Pay Tax Twice on 401(k) Loan?

It is often claimed that you pay double taxes when you borrow money from a 401(k) loan, but this argument has been widely debunked. Usually, you pay off the 401(k) loan using after-tax dollars, and you must pay income taxes again on the money when you take a distribution in retirement. This means that the IRS will tax the amount twice.

The only portion of the loan repayment that is taxed twice is the loan interest on the 401(k) loan. For example, if you borrow $10,000 from your 401(k) account at a 1.5% interest, you will pay back the principal amount of $10,000 without any tax consequences. However, you will pay income taxes on the interest component i.e. $150 when you pay the loan. You will also owe taxes again when you withdraw money in retirement. If you are in the 10% tax bracket, it means you will pay a paltry $15 in taxes. 

Leaving Employer with an Unpaid 401(k) Loan

If you have an unpaid 401(k) loan and you lose your job, you will be allowed a period to fully repay the loan. Usually, the IRS allows 401(k) borrowers up to the tax due date to clear the remaining loan amount. If the loan is not fully paid within the required period, the defaulted loan amount will be counted as a withdrawal for tax purposes. The unpaid amount will be subject to income taxes and early withdrawal penalty tax. Once you leave your job, the employer will no longer deduct loan payments from your paycheck, and you will be responsible for making timely loan payments.

If you decide to take a distribution and you have an unpaid loan, you must tap other sources to pay off the outstanding balance. You can then rollover the 401(k) to an IRA, Solo 401(k), or other tax-advantaged retirement accounts. In limited situations, you may be able to rollover 401(k) loans to another retirement account. If the unpaid 401(k) was included in your taxable income and you pay the loan fully, you will not pay the assessed taxes and penalties.

401(k) Loan vs. 401(k) Withdrawal

An alternative to a 401(k) loan is a 401(k) withdrawal, but the latter is subject to taxes and penalties. If you withdraw funds from a 401(k) before attaining 59 ½, you will owe income taxes and an additional 10% penalty. However, if you have a heavy financial need, you may qualify for a penalty-free hardship distribution. Unlike a 401(k) loan, a hardship distribution does not need to be paid back, but you will deny your retirement money an opportunity to grow tax-deferred.

Borrowing from yourself is a better option than taking a 401(k) distribution. The amount borrowed from a 401(k) is paid back, and this replaces the amount taken out of your 401(k) account. Therefore, if you need short-term funds and you are confident you can pay back the money, a 401(k) is a viable option since it has minimal tax consequences.