If you have a 401(k) retirement account with your employer, you may be able to withdraw funds from it to use as a personal loan. In fact, nearly 20 percent of people with 401(k) retirement accounts have outstanding loans on them. People use these low-interest loans for a myriad of reasons, from dealing with overwhelming financial emergencies to covering the cost of college. However, while these loans are increasingly popular, some tax implications are associated with them. Here’s how taxes work with money borrowed from your 401(k). Before you dive in, however, it’s important to remember that we are not tax professionals and that you should consult with one before making any major financial decisions.
How Much Can You Borrow from a 401(k)?
Depending upon your plan’s rules, you may be able to borrow up to $50,000 from a 401(k) account. However, the rules are a bit more complicated, and they’re predicated on the balance you have in your individual account. According to the IRS:
“The maximum amount that the plan can permit as a loan is (1) the greater of $10,000 or 50% of your vested account balance, or (2) $50,000, whichever is less. For example, if a participant has an account balance of $40,000, the maximum amount that he or she can borrow from the account is $20,000.”
You can have more than one loan from a 401(k) plan, too. However, the combined total of all the loans has to be within accordance of the rules listed above Finally, it’s important to note that 401(k) loans aren’t an individual right; some plans don’t allow loans to be taken out against them. If you’re considering a 401(k) loan for something, you should definitely verify that your plan allows loans first. If your 401(k) plan does allow loans, they’re generally tax-exempt. However, under some circumstances, you could become liable for taxes on an outstanding 401(k) loan.
Five-year Payback Period, with Some Exceptions
If you do decide to take a loan from your 401(k) plan, it’s generally considered tax-exempt if you meet certain requirements. The 401(k) must be paid back within a payback period that’s no longer than five years, and payments must be structured to occur regularly. At a minimum, you should expect to make loan payments every quarter. Additionally, the loan repayments will go back into your 401(k) account, but they won’t be considered contributions. Any outstanding loan balance after the five-year payback period will be considered an early withdrawal, and it’ll be taxed accordingly. However, there’s an exception to the five-year deadline: a 401(k) loan that’s taken out to purchase a primary residence isn’t subject to the mandatory five-year repayment timeline.
If you take a loan against your company’s 401(k) plan and then your employment status ends abruptly, due to quitting or being fired, that loan could lead to tax implications. In most cases, you’ll have 60 days or so to pay back the 401(k) loan in its entirety. In many instances, any remaining balance on the loan that isn’t repaid within the designated period will be considered a retirement distribution and subjected to taxes and potentially other fees.
Leeway on Tax Liabilities: Leave and Military Service
The tax code allows other exemptions to 401(k) loan repayments that help to minimize the tax liabilities of account holders. For example, a 401(k) plan can allow leaves of absence of up to one year for activities such as advanced education or sabbaticals. If it does, then that time isn’t included in the calculation of the loan repayment period. Additionally, plans may allow for the suspension of loan payments for account holders who are mobilized for military service in the reserves or national guard. However, while some 401(k) plans can allow these types of exceptions, not all do. Therefore, if you’re considering one of these loans, be sure to determine what types of repayment exceptions are in place.
Consider All Your Loan Options
Prior to taking out a 401(k) loan, be sure to consider all your options. While there are tax advantages to these loans, alternatives may allow you to accomplish your financial objectives without impacting your retirement plans. For example, if you intended to use a 401(k) to repay high levels of outstanding debt, take note that the debt settlement services offered at National Debt Relief may be a great fit for your personal situation. In other cases, a debt consolidation loan or home equity line of credit (HELOC) may suffice. Before you decide to borrow against your 401(k) account, talk to a trusted advisor about all your loan options. A good advisor can help you determine the loan plan that’ll work best for you.