Is a 401(k) Loan Reportable on Your IRS Income Taxes?

If you participate in a 401(k) retirement plan at work, you might be able to borrow money from the account, assuming your employer permits such loans. Not all employers do, so it’s necessary to check with the plan administrator first. 401(k) loans must adhere to strict IRS rules regarding the amount and repayment period, and failure to repay on time can trigger a 401(k) loan tax and a 401(k) loan penalty.

401(k) Loan Rules of IRS

To receive a loan from a 401(k), the plan must allow it, you must be a plan participant and you must have a positive vested balance in your account. Your employer can delay your participation in its 401(k) for up to one year following your employment start date, and you must be at least 18 years old.

Once you begin participating, you can elect to defer part of your earnings by contributing to your 401(k) up to the federal limits. Your contributions are excluded from your annual taxable income. Employer contributions to your 401(k) are tax-free for you and tax deductible for your employer. Your contributions are immediately 100 percent vested (i.e., you can withdraw all of them if you separate from your employer), but employer contributions might adhere to a vesting schedule that delays your ownership. Certain employer contributions are not eligible for borrowing, vested or not.

401(k) Loan Repayment

The IRS will consider your 401(k) loan to be a reportable, taxable distribution unless you meet either of these conditions:

• You repay the loan within five years.
  
• You use the proceeds to buy or build your primary residence.
  

Even if you satisfy either of these two requirements, the IRS will treat your total loan balance that exceeds the lesser of $50,000 or half the value (but not less than $10,000) of your vested account balance as a taxable distribution. If you’ve already taken a loan, you’ll have to reduce the $50,000 ceiling to the extent of the highest outstanding loan balance during the one year period ending on the day before the new loan minus the outstanding balance on the date of the new loan.

Avoid 401(k) Loan Repayment Taxes

To avoid a taxable distribution, your loan repayments must be paid in substantially equal amounts no less frequently than quarterly. This requirement can be suspended for up to a year if you go on leave without pay, although this does not affect the final due date or the minimum quarterly payment amount. However, you can receive a longer payment holiday and an extended repayment period if you go on active duty in the uniformed services.

If you use the loan to purchase or build your main home, you do not have to meet the five-year repayment period. The plan will specify the maximum repayment period, which is frequently 15 years.

401(k) Loan Interest

You must pay interest on your outstanding loan balance. The interest is deposited into your 401(k) account, meaning you are paying interest to yourself. The rate of interest cannot be less than the rate you would pay a local commercial lender for the same loan. The IRS generally considers an interest rate equal to the prime rate plus two percentage points as sufficient to meet the rate requirements.

Defaulted 401(k) Loan: Deemed Distribution

A deemed distribution is one way your plan administrator can handle a defaulted 401(k) loan. This is not a cash flow and the distribution amount cannot be rolled over into another qualified account or IRA. The sole purpose of a deemed distribution is to determine how much tax and penalty you’ll have to pay on the defaulted amount.

You might trigger a deemed distribution if you leave your job and have an outstanding loan balance that you can’t immediately repay. If you can come up with the default amount within 60 days, you can contribute it to another qualified account or IRA, subject to the annual limits. This is not a rollover. The contribution will reduce or eliminate the income tax due from the distribution, but will not affect any penalty tax.

Defaulted 401(k) Loan: Plan Offset

Under this method, your account balance is offset (reduced) by the defaulted amount. If you can scrape together the offset amount within 60 days, you can roll it over into an IRA or another qualified account, thus avoiding the tax and penalty. There is no limit on the amount that can be rolled over, up to the full offset amount.

If the plan offset arises from plan discontinuation or job severance, you have until the federal income tax filing date, including extensions, to complete the rollover.

If you wish to remedy a deemed distribution, you can make the missed repayments to the plan even after the deemed distribution takes place. The repayments are after-tax, and they are added to the tax-basis of your 401(k) account. In contrast, pretax contributions do not increase the account’s tax basis. You can withdraw money tax-free from your 401(k) up to the basis amount, if any. Unless your 401(k) has a designated Roth component, it’s unlikely your account will have any basis.

Reporting a Loan as Distribution

If you default on the terms of your loan, you will face taxes and a possible 401(k) loan penalty. The defaulted amount will be treated as a taxable distribution, and if you are under age 59 ½, you might be assessed a 10 percent early withdrawal penalty.

The distribution will be indicated on Form 1099-R with a Distribution Code of "L." Include this amount on Form 5329 if you must pay the penalty tax on an early distribution, and attach the form to your annual tax return. Add the penalty tax to Schedule 4 of IRS Form 1040 and to the Other Taxes Section of Form 1040. Add the distribution amount to the Income Section of Form 1040.

Loans from Roth 401(k)

Your employer might offer a designated Roth account as part of the 401(k) plan and might permit loans from the Roth account. The Roth account contains contributions on which you’ve already paid the tax, as well as the earnings on these contributions.

If you default on a Roth 401(k) loan, you’ll only pay tax and penalties on the portion of the loan ascribed to earnings – distributions of contributions are tax-free. The penalty on the distribution of earnings is triggered if the distribution occurs within five years of the initial contribution or, subject to certain exceptions, before age 59 ½.

401(k) Borrowing Vs Withdrawal

Borrowing from your 401(k) has certain advantages over withdrawals. Money you borrow will be repaid, with interest, so you won’t suffer a permanent loss of tax-sheltered retirement funds. You don’t pay taxes or penalties on 401(k) loans unless you fail to fully repay within the loan term, which is usually five years. When you borrow to finance the construction or purchase of your primary home, you can take longer to repay.

However, the amount you can borrow is limited, with an absolute cap of $50,000. If you need more than the allowed loan amount, you might have to resort to a 401(k) withdrawal, if available. You will have to pay taxes, and possibly a 10 percent penalty, on the withdrawal, and 20 percent will be withheld for taxes. If you withdraw money because of a financial hardship, you will first need to take the maximum loan available from your 401(k) and to exhaust all other sources of funds.