What Are the Tax Consequences of Taking a Loan Against Your 401(k)?

If the 401(k) plan you have through your employer includes a provision for loans, you may be able to borrow up to $50,000 or 50% of your vested balance in the plan, whichever is less. According to the IRS, if 50% of your vested balance is less than $10,000, you can borrow $10,000 if your 401(k) plan allows this exception. Generally you have to pay back the loan within five years. But if you are using the loan proceeds to finance the purchase of a home, the payback period can be longer, up to 15 years.

With a 401(k) loan, you are paying the interest to yourself, in effect, by paying it back into your 401(k) account. As indicated on the 401khelpcenter website, the interest you pay on the loan will remain in your 401(k) plan balance until you receive distributions when you retire. Those distributions are subject to federal income tax.

The interest you pay on a 401(k) loan may or may not be tax deductible. As pointed out by Roy Lewis in the Motley Fool, the interest you pay would have to be traced to determine how you used the proceeds of the loan. If you used the proceeds to pay for education expenses, for investment purposes, or to buy a residence, the interest may be deductible. But if any balance in your 401(k) account that is used to secure the loan is attributable to elective deferrals you made, the interest would not be deductible. So unless the vested balance that secures the loan is entirely from contributions your employer made to the 401(k) account, the interest would not be deductible, regardless of how you use the proceeds.

As indicated by Elaine B. Morgillo in an article on Seacoastonline, some 401(k) plans do not allow you to continue making contributions until the loan is fully repaid. This would cause you to miss out on tax-deferred contributions and the earnings you could receive on those contributions to your retirement account. You could also miss out on employer matching contributions.

As explained by Kimberly Palmer in a U.S. News Money article, one of the biggest risks of a 401(k) loan is if you resign from your job or are terminated. In that case the unpaid balance of the loan would to be repaid, generally within 60 days. If you can't repay the loan, the remaining balance would be considered a distribution subject to federal income tax. And, if you are under age 59 ½ you would also be subject to a 10% penalty on the balance as an early withdrawal from a retirement savings account.

Sources:
401(k) Plan Loans '" An Overview '" 401khelpcenter.com
Elaine B. Morgillo, "Financially Speaking: Proceed with caution if borrowing from your 401(k)" '" Seacoastonline.com
Kimberly Palmer, "The New 401(k): Not Just for Retirement Anymore" '" U.S. News Money
Retirement Topics '" Loans - IRS
Roy Lewis, "Retirement Loans: Is the Interest Deductible?" '" Fool.com
Tax Consequences When You Have a 401(k) Loan and Quit or Lose Your Job - TurboTax