The IRS permits holders of 401(k) accounts to borrow money from them. While the Tax Code sets limits on the amount that may be borrowed, it does not limit how the borrower may use the loan proceeds. Thus, borrowers can use a 401(k) loan to pay rent, provided that the employer permits 401(k) loans for that purpose.
Employers May Allow 401(k) Loans to Pay Rent
Employees may borrow money from their 401(k) plans to pay rent as long as their employers permit them to do so. The Internal Revenue Code has rules that govern the tax consequences of 401(k) loans, but does not restrict how the loan proceeds may be used. Thus, tax law permits the use of 401(k) loans to pay rent. However, employers are not required to allow employees to borrow money from their 401(k) plans and even if they allow such borrowing, they may restrict the use of the loan proceeds. Many plans permit loans to purchase a primary residence, but this does not necessarily mean that such plans permit loans to pay rent.
Tax Consequences of 401(k) Loan
Generally, distributions from a 401(k) account are treated as taxable income to the employee and subject to an additional 10 percent penalty tax if the distribution is not a retirement distribution. A 401(k) loan is not treated as a taxable distribution if the loan meets the following conditions: 1) The amount of the loan is the lesser of $50,000 or one-half the present value of the employee's 401(k) account. However, if the present value of the account is less than $20,000, up to $10,000 may be borrowed without being treated as a distribution. 2) The borrower must repay the loan within five years. The five-year limit does not apply to loans used to acquire a principal residence. However, paying rent is not the acquisition of a principal residence. 3) The borrower must repay the loan in level payments. These payments must be made at least quarterly. Any amount that the borrower fails to repay is a taxable distribution.
Failure to follow these rules may result in the loan being treated as a taxable distribution.
Formal Agreement Required
A 401(k) loan must be evidenced by a formal agreement between an employee and employer. The agreement must specify the amount and date of the loan and the repayment schedule. Any applicable loan fees must be specified. The agreement does not have to be signed if the agreement is enforceable under applicable law without being signed. The agreement may either be written on a paper document or delivered through an electronic medium.
Hardship Distributions to Pay Rent
A 401(k) plan may allow employees to receive a hardship distribution because of an immediate and heavy financial need. The amount of the distribution cannot exceed the amount of that need. Whether an employee has an immediate and heavy financial need is based on all relevant facts and circumstances. One circumstance that permits a hardship distribution is when the distribution is for payments needed to prevent the eviction of the employee from the employee’s principal residence.
Thus, if the plan permits, an employee may take a hardship distribution to pay rent and avoid eviction from his principal residence. However, unlike a 401(k) loan, the hardship distribution is taxable to the employee. The 10 percent penalty tax generally applies as well, although there are some exceptions to this rule.
David Altman holds a J.D. from Boston University Law School. He has more than 30 years of experience in legal writing, editing, research and analysis. Altman has contributed to publications such as "Tax Research Consultant," "Tax Return Manual" and "Tax Practice Guides" for Wolters Kluwer.