You may be able to take a loan on your 401K, which is a retirement savings account. Payments into your 401K are usually made pre-tax, but what about loan payments on your 401K? Are 401K loan payments made pre-tax or post-tax?
401K loan payments are made post-tax. When you take out a loan against your 401K, you will be paying taxes twice: once on the loan and once on the contributions. There are other downsides like no interest building on the outstanding loan and withholdings on your contributions and employer matching.
This article explains what a 401K loan is, how 401K loans are taxed, and what happens when you cannot pay your 401K loan back. There is also information on 401K tax contributions and resources you can use to learn more about 401Ks.
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Table of Contents
What Is a 401K Loan?
A 401K is a retirement savings account offered by many employers to their employees as a benefit of a job. Money put into your retirement fund might be matched partially or fully by the employer as an added benefit.
401k loans are another benefit of 401K plans that allow you to take out a loan from your retirement account. You will have to pay back the loan in a certain amount of time with interest, but it will not affect your credit score, and you will not have to go through a credit check like standard loans.
Furthermore, while you need to pay interest on a 401K loan, the money goes to your retirement account instead of a bank or other financial institution. While the money you take out as a loan will not earn interest until you pay it back, the interest that you pay on the loan can make up for some of the difference.
Another downside of 401K loans is that sometimes there are restrictions regarding contributions when a loan is outstanding. For example, if you take out a loan with a three-year repayment plan, you may be prohibited from making contributions to your 401K for three years or until your loan is repaid.
So, the money you take out as a loan will not earn interest, and you can’t add any new money to your account until the loan is repaid. While this is not something you may easily notice, it will affect your retirement plan, especially if you take out a loan that takes many years to repay.
How Are 401K Loans Taxed?
When you have a 401K, you can take a loan out from it and pay yourself back over a certain period. But, how will you be taxed on your loan payments?
All 401K loan payments are exempt from taxes as long as you pay your loan and the interest back on time. When you make your loan payment, you will only pay the principal amount and the interest, not any taxes.
But, when you pay your loan back, you must use post-tax dollars. So, your money will be taxed as normal through your employer when you receive a paycheck. You can then make your payment for your 401K loan.
Paying your 401K loan payments post-tax is unfavorable because you are also paying taxes on the money when you withdraw it from your account. Therefore, you are paying double taxes as a result of taking out a 401K loan.
Furthermore, you do not have to claim your 401K loan money on your tax return. Similar to the above, this only applies if you are paying your loan back on time.
If you need to take out a 401K loan, you should do it as a short-term solution and not take longer than required to pay the money back. Make sure you recognize the tax consequences before making the loan official.
Also, you will need to check with your employer to see what the maximum amount you are allowed to take out for a loan is.
What if I Can’t Pay My 401K Loan?
Although the money is technically yours, you need to pay your loan back on time. Otherwise, you will be penalized in a few ways.
If you can’t pay your loan back, you will have to pay a tax penalty. The result of defaulting on your loan is the same as withdrawing your money before you reach the minimum retirement age required by your plan.
When you default on your loan, you will have to pay taxes as if you were withdrawing your money. One downside of this is that you are likely in a higher tax bracket than you will be when you retire, so you are paying higher taxes.
Another downside of defaulting on your 401K loan is that you will have to pay an early withdrawal penalty since you did not wait until retirement to access your money. Between this penalty and the higher taxes, taking out a 401K loan is not worth it if you can’t pay it back on time.
If you need to take out a 401K loan, make sure you have a feasible plan to pay it back in the designated period. Otherwise, the penalties will cost you, both in the present and when you retire.
How Are 401K Contributions Taxed?
Paying your 401K loan using post-tax dollars differs from how the money you contribute to your 401K is taxed. Every time you put money into your 401K, it is pre-tax.
Your employer handles the transfer of your money, and not having to pay taxes on your 401K contributions is another benefit of saving for retirement.
However, you will need to pay taxes on your 401K money when you withdraw it. Since you are in a lower tax bracket after you retire, it is beneficial to pay taxes when you withdraw money instead of when you contribute it.
Even though your 401K contribution is pre-tax, you will have to pay taxes on any 401K loans. The taxes on your 401K loans are based on your current tax bracket, not your lower, post-retirement tax bracket.
Learn More About 401Ks
Understanding 401Ks and retirement is crucial for your future financial success. The resources in this section will help you understand how 401Ks work and why retirement planning is essential for everyone.
- The New Retirement Savings Time Bomb by Ed Slott from Amazon.com will teach you how to manage your retirement savings. The book has a plan to keep your money safe and how to grow your savings fund as high as possible before retirement.
- Retirement Planning QuickStart Guide by Ted Snow CFP MBA, also from Amazon.com. With his credentials, Snow will surely give you all the credible information you need to start your retirement savings plan. The book includes plans for people of all ages, a digital course, and how to have enough money in your retirement fund.
- If you prefer watching a video over reading, this video from Hagan Newkirk Financial Services on YouTube explains how 401Ks work and when you should borrow against your 401K:
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Conclusion
401K loan payments are made post-tax, and because of this, you will be paying taxes twice on any money you take out as a loan. You will pay taxes once when you pay the loan back and again when you withdraw the money at retirement.
When you take out a 401K loan, make sure you have a plan to pay the money back on time, and that any tax disadvantages are worth the loan.
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