A 401k is an individual retirement plan that is funded by the employee’s contributions, and in some cases, by employer contributions. Employees participate by electing pre-tax automatic payroll deductions to be made into the retirement account. In general, funds disbursed from a 401k account are subject to taxation upon disbursement during retirement or an early withdrawal. However, an employee may withdraw funds prior to retirement without a tax penalty if the disbursement is a loan and it meets the criteria set by the IRS.
Employees may only borrow from their 401k if allowed by the employer’s plan. Employer plans often allow employees to borrow from their 401k plan with relative ease and without the necessity of having a credit check. Every employer plan differs, but if the IRS requirements are met, the borrower will not incur any penalties as long as the loan is repaid. The IRS only allows a person to borrow up to 50 percent or $50,000 of the vested amount, whichever is less.
The IRS requires a borrower to repay the loan within five years. At a minimum, payments must be made at least quarterly. If the loan is for the purchase of a primary home, the employee can take up to 10 years repay the loan. A borrower must pay interest (market rate) on the loan principal, which is not tax deductible and instead becomes taxable as income after the proceeds of the 401k are taken at retirement. An employee can arrange to have repayments made as an automatic payroll deduction after taxation. If an employee leaves his job, he must repay the loan amount within 60 to 90 days.
If the employee defaults on the loan, the loan is treated as a disbursement. This will result in the IRS treating it as an early disbursement if it was made before the employee reached age 59½. The disbursement amount is treated as income for tax purposes and may be subject to an additional 10 percent early withdrawal penalty.
Alternative to a Loan
If an employee is experiencing immediate and heavy financial need, the IRS allows the employer to make a 401k hardship distribution instead of requiring the employee to take a loan. A hardship distribution can be made for one of several reasons: paying medical care for immediate family members; the purchase of a primary residence; payment of tuition or other related educational expenses for immediate family members; the prevention of an eviction or foreclosure; for funeral expenses; or for repairing damage made to an employee’s primary residence. Unlike a loan, the disbursement will be treated as income and subject to an additional 10 percent tax.