The pandemic has taken a financial toll on many of us. While some were laid off early in the pandemic, others may struggle with medical bills or the rising costs of goods and services. No matter what led you to this point, you may be considering a 401(k) loan to help ease the financial burden for your family.
But taking out a 401(k) loan isn’t as simple as depositing the money from your retirement account into your bank account. You need to be aware of significant tax consequences before committing to this type of loan.
Follow along as AA Tax & Accounting Services, LLC explains how a 401(k) loan works and the tax consequences of defaulting on the loan.
How a 401(k) Loan Works
If you need some extra cash and need it relatively quickly, you may be considering a 401(k) loan instead of a traditional one. Any money you borrow from your retirement savings account is tax-exempt if you pay the loan back in the stipulated period.
When borrowing from your 401(k), you can borrow the lesser of 50% of your 401(k) balance or $50,000. Any interest you pay over the specified period will return to your 401(k) account since you borrowed against your savings.
Once approved for the loan, you will be granted five years to pay back the money into your retirement savings account. If you leave your current job during this repayment period, you must pay the unpaid amount back by the tax due date. If you cannot make the repayments, you may be forced to default on your 401(k) loan — resulting in serious tax consequences.
For example, the Internal Revenue Service will consider you defaulting on your loan if you have missed multiple payments and have an outstanding balance of $10,000. If you fall within the 22% tax bracket, you must pay $2,200 in income taxes when filing your tax return.
Plus, if you are under 59 ½, you will owe an additional $1,000 in early withdrawal fees. You would owe the government $3,300 in taxes from your defaulted 401(k) loan.
401(k) Loan vs. 401(k) Withdrawal
For those considering a 401(k) loan, a 401(k) withdrawal may be more beneficial to your needs. However, a 401(k) withdrawal does come with taxes and penalties from the getgo. In most cases, an individual can early withdraw from their 401(k) at any time and for any reason. But to do this, you will pay a 10% penalty for withdrawing before the age of 59½. A few exceptions to the penalty include:
- Total and permanent disability
- Unreimbursed medical expenses
- Employee separated from service at age 55 or older
- Hardship distributions (medical or funeral expenses, eviction or foreclosure, etc.)
Should you take out a 401(k) loan? If you are confident that you will be able to make the payments over the next five years, then a 401(k) loan is a viable option for short-term funds with minimal tax consequences.
Tax Consulting Services in Cedar City, Utah
If you’re considering taking out a 401(k) loan, we recommend consulting certified public accountants like AA Tax & Accounting Services to understand all the tax consequences better. We have the experience to guide individuals on their retirement finances with our top-rated tax consulting services.
If you’re overwhelmed with the amount of information, the AA Tax & Accounting Services team can help navigate the retirement planning process. Contact us to schedule an appointment.