How Retirement Plan Loans Affect Your Taxes

Taking retirement plan loans can provide immediate relief to an individual facing an emergency financial situation or is in need of funds that are not otherwise available. Most retirement plans that are defined contribution plans, such as a 401(K) permit some form of borrowing through loans. The amount available is usually limited to a percentage of the plan’s total assets and can be for just about any reason.

IRS Tax Recovery

Taking out a retirement plan loan will increase an individual’s taxable income as any distribution taken from a retirement plan is treated as ordinary income. Since the amount taken out is based on pre-tax dollar going in the plan, the Internal Revenue Service (IRS) has an interest in recovering the taxes on the non-taxed principal first, followed by the gains earned on the principal.  

10 Percent Excise Fee

If the amount borrowed is not provided for as an exception by the IRS (i.e. first-time homebuyers and nursing home care), an additional excise penalty of 10 percent is charged for money taken out prior to age 59-1/2. The fee is charged up front with the entire amount subject to taxation as ordinary income and is reportable on the tax return in the year that the distribution is taken from the retirement plan.


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