When you've taken advantage of your ability to borrow from your 401(k) plan, you usually make repayments through paycheck deductions. However, unlike many other deductions, your repayments won't get you any tax breaks. In fact, like many other types of loans, you usually don't report any details about your 401(k) loan on your taxes. However, in certain circumstances, your loan could become a taxable distribution, in which case you will have some extra tax reporting obligations.
Loans Repaid as Agreed
When you repay your loan as you agreed to when you borrowed from your 401(k) plan, you don't have any tax consequences. The loan, like any other money you borrow, doesn't count as taxable income because your net worth didn't change. When you make repayments, you don't get to claim a deduction because you're simply putting the money back, not making a new contribution to the account. Finally, because you're repaying the loan, you don't have to report it as a distribution.
You only get into tax trouble with 401(k) loans if you don't repay them on time. If you default on the loan, the Internal Revenue Service treats it as if you had taken a distribution of the remaining loan balance. Say you borrowed a $20,000 and had paid back $5,000 when you lost your job and stopped paying back the loan. You'd have to report an extra $15,000 in taxable income for the year.
Income Tax Reporting
If you default on your 401(k) loan, you'll receive a Form 1099-R that shows how much you're deemed to have taken out based on the default in Box 1. You can use either Form 1040 or Form 1040A, but not Form 1040EZ because it doesn't have a line for pension and annuity distributions. The defaulted amount gets added to your taxable income for the year.
Early Withdrawal Penalties
If you're younger than 59 1/2 when you default on your 401(k) loan, you'll also have to pay a 10 percent early withdrawal penalty. To figure the penalty, use IRS Form 5329. You might get out of the penalty if you qualify for an exemption, such as medical expenses that exceed a threshold percentage of your annual income or if you suffer a permanent disability, but you won't get out of filing Form 5329. If you have an exception, report it on line 2 and you can avoid the penalty.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."