When is a 401k loan taxable?

When borrowing for short-term emergency needs, a 401(k) loan can be a better option than a hardship withdrawal. Usually, if your employer allows 401(k) loans, you can borrow the lesser of $50,000 or 50% of your vested account balance. You must make timely loan payments to pay off the loan. 

A 401(k) loan is usually tax-exempt, but it may become taxable when you default on loan repayments. Usually, if you are unable to repay the loan, the unpaid loan amount may be considered a distribution, which is subject to income tax and a potential early withdrawal penalty.

How 401(k) loan works

A 401(k) loan is the amount borrowed against retirement savings held in a 401(k) account. You can borrow against your retirement savings when you have an urgent need for cash to pay college or medical expenses. You must make loan payments on time to your 401(k) plan, at least quarterly. Most 401(k) require participants to pay off the loan through payroll deductions to reduce the risk of missing out on a payment and create a tax liability.

If you decide to opt out of payroll deductions and instead make loan payments on your own, you must make timely payments according to the plan's schedule. You can pay the loan using a check or wire transfer. However, if you miss out on a payment, the retirement plan may consider the unpaid loan a distribution. The distribution will be treated as a taxable income, and you will owe income tax and an additional early withdrawal penalty if you are below 59 ½.

Defaulting on a 401(k) loan on the job

If you are unable to make timely payments to the 401(k) loan, your loan could be considered to be in default. There are significant consequences for defaulting on a 401(k) loan, especially if you are younger than 59 ½. In addition to paying income tax at your tax bracket, you could owe a 10% penalty tax.

For example, if you had a $20,000 401(k) loan, and you default when the outstanding loan balance is $15,000, you will pay taxes on this amount. If you are in the 20% tax bracket, you will be required to pay $3,000 in income taxes, an additional $1500 (10%) as an early withdrawal penalty. In total, you could owe up to $4,500 in taxes.  

What to Expect If You Lose Your Job and You Have a 401(k) Loan

If you lose your job before paying the 401(k) loan fully, the unpaid balance could generate a tax bill. When you leave your job, your employer will require you to pay off the loan within a shorter term than you had expected. For example, if you lose your job when you have two years remaining to repay the loan, you will be required to pay off the loan before the tax due date of the following year to avoid paying taxes.

If you are unable to pay the outstanding loan before the tax due date, the plan may reduce your 401(k) balance to recoup the unpaid loan amount. This is known as a loan offset, and the offset amount is considered a distribution that is subject to taxation. However, if you come up with the money, you can avoid the tax liability by rolling over the loan offset to an IRA.

Taxes on 401(k) Loan Interest

The amount of 401(k) loan taken from a 401(k) is not subject to taxation as long as you make loan payments on time. However, the only component of a 401(k) that is taxed is the loan interest. When making loan payments, you must use after-tax dollars to pay the loan interest. This means that the interest component is already taxed when it is paid into your 401(k) account. This interest component is taxed again when you withdraw money in retirement. Since interest makes up a small portion of the loan payment, the tax impact is almost negligible.