Pay Interest or Taxes on 401(k) Loan?

Dear Tax Talk,

If I have to take a loan against my 401(k), will I have to pay taxes on the loan or just interest? Any idea how much the interest would be? Term limits? Example: Five years max or can I pay for up to 20 years? Is there a limit to how much I can borrow? Example: 50% of balance, $50,000 max? Lots of questions, but trying to make the best choice we can.

Thank you.


Dear Beverly,

Borrowing against your 401(k) may be one of the best remaining tax loopholes. Unless you're facing job insecurity, borrowing will allow you to use your own retirement money to achieve current financial goals while repaying yourself interest.

Most 401(k) plans allow borrowing. The maximum you can borrow is $50,000, but if your vested interest in the account is less than $100,000, then the maximum is 50% of that vested amount. The interest is generally not deductible. If you borrow $50,000 and repay yourself $2,500 in interest (5% rate), that $2,500 is considered income to you when you retire. Because you're not allowed a deduction, you're getting double taxed. But if you need the money, this is the cost of doing business.

Unless you're buying a first home, the loan needs to be repaid in level payments within five years. If you lose your job prior to repaying the loan and you're younger than 59½ and can't immediately repay the loan, you can get hit with a 10% premature withdrawal penalty.

Considering the tightened credit market, a 401(k) loan may be your only option. At least you won't be turned away because of your credit score as there is no lender approval needed.

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