It's always nice to have a relative you can go to for money in an emergency. But if you have a 401(k) plan that allows you to borrow money from your balance, you can be your own helpful relative! In most cases, as long as you pay back your 401(k) loan according to the rules, the money you borrow is not reportable as taxable income. If you don't repay properly, though, you'll have some explaining to do to your Uncle Sam.
Loans Are Not Income
Say you're moving to a new apartment, and you need a pickup truck to transport your stuff. So you borrow one from a friend, use it for a day, and then return it. Did you ever "own" the pickup? Of course not. You just got to use it temporarily. The same principle applies when you borrow money. The lender gives you cash, you use it for a while, and then you return it. When the dust settles, you will have none of the lender's money -- and, in fact, the lender will have some of yours, in the form of interest on the loan. Since you won't make any money on the transaction, you will realize no income, so the money you initially get from the loan does not have to be reported on your income taxes.
The 401(k) Wrinkle
A loan from your 401(k) is a little different from a typical consumer loan because the money you're borrowing comes out of your retirement savings. In other words, you're borrowing your own money. Remember that your 401(k) contributions -- the money your employer takes out of your paycheck and puts into the account -- are untaxed. You pay taxes on the money only when you make withdrawals later on in life. But a loan from your 401(k) doesn't usually count as a withdrawal for the same reason a consumer loan doesn't count as income: The money all winds up back in your 401(k), so there's nothing to tax -- and therefore, nothing for you to report to the folks at the Internal Revenue service. However, the IRS limits the amount of a nontaxable 401(k) loan to $50,000, or 50 percent of your vested balance, whichever is lower. Anything above that is considered a withdrawal (the IRS uses the term "distribution"), and it is taxable income.
But if You Don't Repay ...
Everything you've just read depends on one not-so-minor detail: You have to actually repay the loan. When you don't repay borrowed money, then the unpaid amount becomes taxable income. It makes sense when you think about it: You got money to use, and you didn't have to pay it back. That's the very definition of income. This fact often proves something of an eye-opener to people who manage to get a debt reduced or canceled and think their troubles are over.
401(k) Repayment Rules
As it happens, the federal tax code is very strict about the rules for paying back a loan from a 401(k). Fail to follow those rules, and the borrowed amount becomes taxable income. Not only that, but if you're younger than 59 1/2, you'll have to pay an extra 10 percent tax as a penalty for pulling money out of your tax-deferred retirement savings too early. When you borrow from your 401(k), you must repay the money within five years, unless you use the money to buy a home. Further, you have to make at least one payment every three months, and those payments have to be roughly equal. So you can't simply wait five years and pay it all off at once.