Some 401(k) plans permit participants to borrow directly from their funds. If plan participants may take out loans, the written plan description states that borrowing is allowed. Although withdrawals from a 401(k) by participants younger than 59 1/2 usually result in a penalty, loans from 401(k) funds do not trigger a penalty. Nor is there a need to report the loan amount as income, if the loan meets borrowing limits and repayment conditions.
Not Taxable Income
A loan from your 401(k) will not be treated as taxable income and is not to be reported on your income taxes. You made the original contributions to your 401(k) with pretax dollars, and the tax on those contributions is deferred until you begin taking withdrawals after age 59 1/2. When you borrow from your 401(k) and then repay that money, those funds retain their qualified status and will not be subject to taxes until you begin your withdrawals after 59 1/2.
The Internal Revenue Code subjects 401(k) loans to strict borrowing limits, permitting a participant to borrow only up to 50 percent of the vested account balance, up to a maximum of $50,000. The participant must reduce the $50,000 amount if there is an outstanding loan from the plan or any other plan of the employer during the one-year period ending the day before the loan. The amount of the reduction is the participant’s highest outstanding loan balance during the one-year period minus the outstanding balance on the date of the new loan.
The Internal Revenue Code imposes conditions on the time for full repayment and the repayment amounts. The loan must be repaid within five years, unless the loan funds are used to buy the participant’s principal residence. The loan must be repaid at least quarterly, in substantially level payments, over the life of the loan.
Funds For Home Purchase
If the 401(k) loan funds are used to purchase the participant's main home, an important exception applies. The loan need not be repaid within the five-year period.
If you have not repaid the 401(k) loan in full at the end of five years and the funds were not used to buy your principal place of residence, the unpaid portion is treated as a taxable distribution. In such a case, you will pay a 10 percent penalty for early withdrawal on the unpaid portion of the loan if you are younger than 59 1/2 years.
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