Borrowing from Your 401(k)? One Wrong Move Could Trigger a Massive Tax Bill
Borrowing from your 401(k) may seem simple, but one mistake, like leaving your job, can trigger taxes, penalties, and long-term damage to your retirement savings. Understanding the rules before you borrow is critical.
Borrowing from your 401(k) might seem like an easy way to access cash, no credit check, low interest, and you’re paying yourself back. But one wrong move can trigger immediate taxes, penalties, and a permanent hit to your retirement savings. The IRS has strict rules on how 401(k) loans must be repaid and what happens if you leave your job before it’s paid off. Understanding those rules before you borrow can help you avoid costly surprises.
How 401(k) Loans Work
Most employer-sponsored 401(k) plans allow participants to borrow up to the lesser of $50,000 or 50% of their vested balance. Loans typically have to be repaid within five years through automatic payroll deductions, and the interest you pay goes back into your account.
On paper, it looks simple. You’re borrowing from yourself and putting the money back over time. But the biggest risk comes if your employment status, or repayment schedule, changes.
The Costly Mistake: Leaving Your Job Before Repayment
If you leave your employer, voluntarily or otherwise, with an outstanding 401(k) loan, the clock starts ticking. Under IRS rules, you must repay the entire remaining balance by the tax-filing deadline of the following year.
If you don’t repay it in time, the IRS classifies the unpaid balance as a “deemed distribution.” That means:
The outstanding amount is treated as taxable income in that year.
If you’re under age 59½, you’ll also face a 10% early withdrawal penalty.
Example:
If you owe $20,000 on a 401(k) loan when you change jobs and don’t repay it, that $20,000 becomes taxable income. Assuming a 22% federal bracket, you’ll owe $4,400 in federal tax, plus a $2,000 early withdrawal penalty—a total of $6,400 lost instantly.
Our analysis at Greenbush Financial Group shows that many borrowers underestimate this risk, particularly if they expect to switch jobs or retire early.
Why the Real Cost Is Even Higher
Taxes and penalties are only part of the loss. When you default on a 401(k) loan:
You lose future growth on the money permanently removed from your retirement plan.
You can’t simply “rollover” the unpaid balance into an IRA—it’s treated as distributed cash.
In long-term projections, a $20,000 distribution today can mean over $60,000 less in retirement savings 20 years from now, assuming a 7% annual return.
Smart Ways to Borrow Without Derailing Your Retirement
If you’re considering a 401(k) loan, these steps can help minimize the risk:
Understand your plan’s terms. Confirm repayment rules, interest rates, and whether you can continue contributing while repaying the loan.
Have a backup plan. Keep cash reserves or other assets available in case you leave your job unexpectedly.
Avoid borrowing for depreciating expenses. Using retirement funds for short-term needs like vacations or vehicles can compound long-term losses.
Check your employment stability. If you expect to change jobs soon, it’s better to wait or use other financing options.
Compare alternatives. A home equity line of credit (HELOC) or personal loan may cost less in taxes and missed growth over time.
At Greenbush Financial Group, we often help clients run side-by-side projections showing the real long-term cost of borrowing from their 401(k) compared to other options. In most cases, the total impact of lost compounding far outweighs the short-term benefit of easy access to funds.
The Bottom Line
A 401(k) loan can make sense in limited cases, such as paying off high-interest debt or covering an emergency expense when other options are exhausted. But understanding the repayment rules—and the risk of job loss—is critical. One mistake, like leaving your employer before repaying the loan, can trigger thousands in taxes and permanently shrink your retirement balance.
Before taking out a loan, it’s worth modeling different scenarios with a financial planner to ensure your short-term decision doesn’t create a long-term setback.
Rob Mangold
About Rob……...
Hi, I’m Rob Mangold. I’m the Chief Operating Officer at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally, professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, please feel free to join in on the discussion or contact me directly.
FAQs: 401(k) Loan Rules and Risks
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What’s the maximum I can borrow from my 401(k)?Generally, up to $50,000 or 50% of your vested balance, whichever is less.
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How long do I have to repay a 401(k) loan?Most plans require repayment within five years, except when borrowing to purchase a primary residence.
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What happens if I default on my loan?The unpaid balance is treated as a taxable distribution and may incur a 10% early withdrawal penalty if you’re under age 59½.
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Can I roll my 401(k) loan into an IRA or new employer plan?No, loans cannot be rolled over. The balance must be repaid directly to avoid taxes.
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Should I ever take a 401(k) loan?Only if the need is critical and you’re confident you’ll remain employed through the repayment period.
Coronavirus Relief: $100K 401(k) Loans & Penalty Free Distributions
With the passing of the CARES Act, Congress made new distribution and loan options available within 401(k) plans, IRA’s, and other types of employer sponsored plans.
With the passing of the CARES Act, Congress made new distribution and loan options available within 401(k) plans, IRA’s, and other types of employer sponsored plans. These new distribution options will provide employees and business owners with access to their retirement accounts with the:
10% early withdrawal penalty waived
Option to spread the income tax liability over a 3-year period
Option to repay the distribution and avoid taxes altogether
401(k) loans up to $100,000 with loan payments deferred for 1 year
Many individuals and small businesses are in a cash crunch. Individuals are waiting for their IRS Stimulus Checks and many small business owners are in the process of applying for the new SBA Disaster Loans and SBA Paycheck Protection Loans. Since no one knows at this point how long it will take the IRS checks to arrive or how long it will take to process these new SBA loans, people are looking for access to cash now to help bridge the gap. The CARES Act opened up options within pre-tax retirement accounts to provide that bridge.
10% Early Withdrawal Penalty Waived
Under the CARES Act, “Coronavirus Related Distributions” up to $100,000 are not subject the 10% early withdrawal penalty for individuals under the age of 59½. The exception will apply to distributions from:
IRA’s
401(K)
403(b)
Simple IRA
SEP IRA
Other types of Employer Sponsored Plans
To qualify for the waiver of the 10% early withdrawal penalty, you must meet one of the following criteria:
You, your spouse, or a dependent was diagnosed with the COVID-19
You are unable to work due to lack of childcare resulting from COVID-19
You own a business that has closed or is operating under reduced hours due to COVID-19
You have experienced adverse financial consequences as a result of being quarantined, furloughed, laid off, or having work hours reduced because of COVID-19
They obviously made the definition very broad and it’s anticipated that a lot of taxpayers will qualify under one of the four criteria listed above. The IRS may also take a similar broad approach in the application of these new qualifying circumstances.
Tax Impact
While the 10% early withdrawal penalty can be waived, in most cases, when you take a distribution from a pre-tax retirement account, you still have to pay income tax on the distribution. That is still true of these Coronavirus Related Distributions but there are options to help either mitigate or completely eliminate the income tax liability associated with taking these distributions from your retirement accounts.
Tax Liability Spread Over 3 Years
Normally when you take a distribution from a pre-tax retirement account, you have to pay income tax on the full amount of the distribution in the year that the distribution takes place.
However, under these new rules, by default, if you take a Coronavirus-Related Distribution from your 401(k), IRA, or other type of employer sponsored plan, the income tax liability will be split evenly between 2020, 2021, and 2022 unless you make a different election. This will help individuals by potentially lowering the income tax liability on these distributions by spreading the income across three separate tax years. However, taxpayers do have the option to voluntarily elect to have the full distribution taxed in 2020. If your income has dropped significantly in 2020, this may be an attractive option instead of deferring that additional income into a tax year where your income has returned to it’s higher level.
1099R Issue
I admittedly have no idea how the tax reporting is going to work for these Coronavirus-Related Distributions. Normally when you take a distribution from a retirement account, the custodian issues you a 1099R Tax Form at the end of the year for the amount of the distribution which is how the IRS cross checks that you reported that income on your tax return. If the default option is to split the distribution evenly between three separate tax years, it would seem logical that the custodians would now have to issue three separate 1099R tax forms for 2020, 2021, and 2022. As of right now, we don’t have any guidance as to how this is going to work.
Repayment Option
There is also a repayment option associated with these Coronavirus Related Distributions, that will provide taxpayers with the option to repay these distributions back into their retirement accounts within a 3-year period and avoid having to pay income tax on these distributions. If individuals elect this option, not only did they avoid the 10% early withdrawal penalty, but they also avoided having to pay tax on the distribution. The distribution essentially becomes an “interest free loan” that you made to yourself using your retirement account.
The 3-year repayment period begins the day after the individual receives the Coronavirus Related Distribution. The repayment is technically treated as a “rollover” similar to the 60 day rollover rule but instead of having only 60 days to process the rollover, taxpayers will have 3 years.
The timing of the repayment is also flexible. You can either repay the distribution as a:
Single lump sum
Partial payments over the course of the 3 year period
Even if you do not repay the full amount of the distribution, any amount that you do repay will avoid income taxation. If you take a Coronavirus Related Distribution, whether you decide to have the distribution split into the three separate tax years or all in 2020, if you repay a portion or all of the distribution within that three year window, you can amend your tax return for the year that the taxes were paid on that distribution, and recoup the income taxes that you paid.
Example: I take a $100,000 distribution from my IRA in April 2020. Since my income is lower in 2020, I elect to have the full distribution taxed to me in 2020, and remit that taxes with my 2020 tax return. The business has a good year in 2021, so in January 2022 I return the full $100,000 to my IRA. I can now amend my 2020 tax return and recapture the income tax that I paid for that $100,000 distribution that qualified as a Coronavirus Related Distribution.
No 20% Withholding Requirement
Normally when you take cash distributions from employee sponsored retirement plans, they are subject to a mandatory 20% federal tax withholding; that requirement has been waived for these Coronavirus Related Distributions up to the $100,000 threshold, so plan participants have access to their full account balance.
Cash Bridge Strategy
Here are some examples as to how individuals and small business owners may be able to use these strategies.
For small business owners that intend to apply for the new SBA Disaster Loan (EIDL) and/or SBA Paycheck Protection Program (PPP), the underwriting process will most likely take a few weeks before the company actually receives the money for the loan. Some businesses need cash sooner than that just to keep the lights on while they are waiting for the SBA money to arrive. A business owner could take a $100,000 from the 401(K) plan, use that money to operate the business, and they have 3 years to return that money to 401(k) plan to avoid having to pay income tax on that distribution. The risk of course, is if the business goes under, then the business owner may not have the cash to repay the loan. In that case, if the owner was under the age of 59½, they avoided the 10% early withdrawal penalty, but would have to pay income tax on the distribution amount.
For individuals and families that are struggling to make ends meet due to the virus containment efforts, they could take a distribution from their retirement account to help subsidize their income while they are waiting for the IRS Stimulus checks to arrive. When they receive the IRS stimulus checks or return to work full time, they can repay the money back into their retirement account prior to the end of the year to avoid the tax liability associated with the distribution for 2020.
401(k) Plan Sponsors
I wanted to issue a special note the plan sponsors of these employer sponsored plans, these Coronavirus Related Distributions are an “optional” feature within the retirement plan. If you want to provide your employees with the opportunity to take these distributions from the plan, you will need to contact your third party administrator, and authorize them to make these distributions. This change will eventually require a plan amendment but companies have until 2022 to amend their plan to allow these Coronavirus Related Distributions to happen now, and the amendment will apply retroactively.
$100,000 Loan Option
The CARES Act also opened up the option to take a $100,000 loan against your 401(k) or 403(b) balance. Normally, the 401(k) maximum loan amount is the lesser of:
50% of your vested balance OR $50,000
The CARES Act includes a provision that will allow plan sponsors to amend their loan program to allow “Coronavirus Related Loans” which increases the maximum loan amount to the lesser of:
100% of your vested balance OR $100,000
To gain access to these higher loan amounts, plan participants have to self attest to the same criteria as the waiver of the 10% early withdrawal penalty. But remember, loans are an optional plan provision within these retirement plans so your plan may or may not allow loans. If the plan sponsors want to allow these high threshold loans, similar to the Coronavirus Related Distributions, they will need to contact their plan administrator authorizing them to do so and process the plan amendment by 2022.
No Loan Payments For 1 Year
Normally when you take a 401(K) loan, the company begins the payroll deductions for your loan payment immediately after you receive the loan. The CARES act will allow plan participants that qualify for these Coronavirus loans to defer loan payments for up to one year. The loan just has to be taken prior to December 31, 2020.
Caution
While the CARES ACT provides some new distribution and loan options for individuals impacted by the Coronavirus, there are always downsides to using money in your retirement account for purposes other than retirement. The short list is:
The money is no longer invested
If the distribution is not returned to the account within 3 years, you will have a tax liability
If you use your retirement account to fund the business and the business fails, you could have to work a lot longer than you anticipated
If you take a big 401(k) loan, even though you don’t have to make loan payments now, a year from the issuance of the loan, you will have big deductions from your paycheck as those loan payments are required to begin.
Michael Ruger
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
