If you participate in a 401(k) plan at work, you’re probably planning for retirement. But if you need money before retirement, should you borrow from your 401(k)?
Whether that’s a good idea depends on your personal financial situation – and in the process of making the decision about lending money to yourself, you may have questions regarding the tax consequences.
For instance, though you probably know the initial borrowing has no federal income tax effect, you might be wondering whether the interest you pay will be deductible. In general, the answer is no. That’s true even when you use 401(k) loan proceeds for your home.
Ordinary loan repayments are not taxable events either.
That is, you don’t have to pick up the interest you repay into your account as taxable income. And, though you’re increasing your 401(k) account with the principal portion of each payment, that amount is not considered a contribution. You can still make pre-tax contributions up to the annual limit ($17,500 for a traditional 401(k) during 2014, plus an additional $5,500 when you’re age 50 or older).
What if you default on the 401(k) loan?
The balance of your loan is considered a distribution to you, and you’ll have to report it as ordinary income on your federal tax return. In addition, when you’re under age 59½, a 10% early-withdrawal penalty typically applies.
Borrowing from a 401(k) is an important financial decision, and it’s essential to review all of the tax and financial implications before you sign the loan documents.