Is Borrowing Money From 401(k)s Penalized?

Even though you generally can’t withdraw from your 401(k) plan until age 59 1/2, you might be able to borrow money from the plan for any reason, at any time. As long as your loan meets the IRS requirements and you repay it as you agreed, you won’t pay any taxes or penalties if you borrow money from your 401(k) plan. However, before you start planning how to use your loan, make sure your 401(k) plan permits loans and remember that you have to repay the loan with interest.

Loan Size Limits

You can only borrow so much from your plan before the IRS gets upset. First, only your vested account balance is included when figuring your loan limits. “Vested” means the amount that you would get to keep if you left the company. Second, you can’t borrow more than $50,000 or one-half your vested account balance, whichever is smaller. For example, if your vested account balance is $88,000, your loan would be limited to $44,000. If your vested account balance is $100,000 or more, you’re limited to $50,000 in loans.

Repayment Period Specifications

Loans must be repaid over no more than five years, using substantially level, or equal, payments. The payments have to be made at least quarterly. For example, you can’t set up a 401(k) loan where you don’t have to make any payments the first four years and then you have to pay the entire amount in the final year. The only time you can get a longer repayment period is if you use the proceeds to purchase your main home. Sorry, money you take out for your vacation home is stuck with a five-year repayment period.

Loans Deemed Distributions

If you don’t repay the loan as you were supposed to, you’re treated as if you took whatever balance you owe on your 401(k) loan as a distribution. This means the entire amount is taxable in the year you took the distribution and, assuming you’re under 59 1/2 years old, subject to the 10 percent additional tax. To avoid defaulting on your loan by accidently missing a payment, see if your employer will automatically deduct your repayments from your paycheck so you don’t have to remember.

Exceptions to Penalties

Exceptions to the 10 percent additional tax on early distributions are determined at the time the loan is deemed a distribution, not at the time you take out the loan. For example, if you take out a loan in 2012 and then suffer a permanent disability in 2014 that makes it impossible to pay back the loan, you qualify for an exception to the 10 percent additional tax because when the loan is deemed a distribution in 2014, you had a permanent disability. However, you'd still have to pay the regular income taxes.

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