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Drill Down: Taxes and Penalties from 401k Loans
There are some dangers in borrowing from your 401k that you should be aware of. First, let’s suppose that you have to change jobs after you borrowed the money, but before you were able to repay the loan. Perhaps you have a better opportunity somewhere else, or maybe you were laid off. In most cases, you have to repay your loan immediately.
Here’s what happens if you DO NOT pay back your 401k loan in time: The IRS will say that you have withdrawn money from your 401k plan and therefore are responsible to pay the income tax. Assuming that you borrowed $400 and haven’t repaid it by the time you leave your employer, you will now be responsible for $400 of “taxable income.” Since you found yourself needing to take out the loan in the first place, you likely do not have the cash necessary to pay the taxes.
That’s not all. If you are under 59½ years old, the IRS will say that you took an early withdrawal from your plan. You are subject to a penalty of ten percent of what you borrowed, in addition to the taxes. And again, you may not have the cash you need to pay the IRS.
Bill Says: Having a debt you cannot pay is bad. Having a debt to the IRS that you can’t pay is very, very bad.
Had you borrowed the money anywhere else, taking your time to pay off the loan would not have cost you taxes and penalties to the IRS. So keep in mind that, when you borrow from your 401k, you may have to suddenly come up with enough money to pay your loan off quickly.
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Lesson 1: What the Heck is a 401k, and What’s So Great About It?
Lesson 2: Contributions to Your 401k
Lesson 3: Investments “Cook Book” Approach
Lesson 4: Investments: How Investments Work
» Lesson 5: Loans and Hardship Withdrawals from Your 401k
Lesson 9: Your 401k, Your Other Assets, and Your Life
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