What are the Tax Penalties of Getting a 401K Loan?
A 401k loan is a tool that was developed to give people access to their retirement before they turn 59 1/2. It is designed to give you access as a loan that will be repaid on specific terms. It is similar to obtaining a loan from the bank except you will just repay your retirement instead of a lender. It should not be done frivolously and without a very good reason. Many people worry about the tax penalties and implications associated with a 401k loan. Consider these factors before taking money out of your retirement plan.
Are There Penalties?
There are no specific penalties associated with a 401k loan. Many people confuse a 401k loan with cashing out your 401k. If you cash out your 401k before you are 59 1/2, there will be a 10% early distribution penalty. In addition to a 10% penalty, you will have to pay taxes on the amount. This usually means that you will lose almost half of your 401k before you can spend any of it. Therefore, a cash out is not a good idea. However a 401k loan does not incur any penalties. With that being said, there are negative tax implications in other forms though.
Repaying the Loan
Getting the money into your 401k initially was easy. You just set up a percentage of your paycheck that you wanted to deduct and it automatically went in. This money was sent into the 401k before taxes were taken out, so you probably didn't even miss it. However, repaying the loan will not be so easy. When you repay a loan, you are paying it with after-tax dollars. This means, it will take you a lot longer to repay the debt than normal. For example, in order for you to pay back $100 of loan, you might have to make around $125 actual dollars. The tax comes out of your paycheck and then you make a payment with interest back to the 401k.
Not Tax Deductible
Another negative tax implication associated with a 401k loan is that the interest that you repay is not tax deductible. You will pay yourself a rate of return around 6 or 7 percent. When it comes time to do your taxes, none of that can be deducted. With other forms of interest such as a mortgage or student loan, you can deduct it from income taxes and the hit will not be as hard. However, this type of loan does not enjoy that luxury. So you have to pay it back with after-tax dollars and you cannot deduct it. The government has set it up to discourage 401k loans at any point. A better alternative may be to take out a home equity loan as the interest can be deducted.
Should You Borrow?
The question of whether or not you should take out a 401k loan is one that has to be answered individually. As a general rule, it is not a good idea. If you can come up with the money you need from any other source, it would probably be better. However, if you are in dire need of the money, it can be a good alternative.