Should you get a 401 (k) loan to pay your taxes?

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As Tax Day approaches (April 18 in most places this year), you might be looking at a huge tax bill and wondering where you’ll find the money to pay it. .

And then you might think: Hmmm, I have some money in my 401 (k). Maybe I should pull out a 401 (k) loan write a check to the IRS….

About 90% of 401 (k) participants are able to borrow against their balance and about 11% do so each year. However, you cannot borrow from an Individual Retirement Account. So should you take out a 401 (k) loan for your taxes? Perhaps.

Easy access without financial risk

“A 401 (k) loan is a very easy way to access cash without putting yourself at financial risk,” says Andrew Meadows, San Francisco-based vice president of brand and culture at Ubiquity Retirement + Savings which manages the pension plans of small businesses.

Indeed, taking out a 401 (k) loan is not like a traditional bank loan.

For example, there is no credit check and obtaining the loan does not affect your credit score; Applying for a standard loan could lower your credit score by 5 to 10 points because the new credit application appears on your credit report.

With a 401 (k) loan, you only pay back interest, usually automatically from your paycheck. Typically, you have to repay the loan within five years.

How much you will pay for a 401 (k) loan

Typically, you pay an interest rate on a 401 (k) loan equal to one or two percentage points above the prime rate, which currently means between 4.5% and 5.5%. In contrast, putting your taxes on your credit card bill could charge you an interest rate of around 15%.

And unlike a 401 (k) withdrawal – if you can get your employer to leave one for you – you usually won’t pay income tax or penalty tax with a 401 (k) loan.

Because of these benefits, “we often see an increase in 401 (k) loan applications at tax time by small business owners and individual contract employees who have solo 401 (k) plans in place,” he said. Meadows said. “Their tax bills can be pretty huge.”

Disadvantages of 401 (k) loans

Now, the disadvantages of 401 (k) loans:

There is a limit to the amount you can borrow – no more than 50% of your acquired account balance or $ 50,000, whichever is less. One exception: if your 401 (k) is less than $ 20,000, you may be able to borrow up to $ 10,000.

Another downside: If you leave your employer before your 401 (k) is paid off, you will either have to find the rest of the money within 60 days or face a tax bill, as the IRS will consider the outstanding loan as a taxable distribution. If you are under 55, that will mean paying ordinary income tax on the money and possibly a 10% penalty.

Also, it can take about a month to get your hands on the money after you apply for a 401 (k) loan. So you’ll likely need to apply for one in early or mid-March to make sure you have the funds when your tax return is due. “It can be a bit of an administrative nightmare,” Meadows said. “Loan checks are not easy to cut. So you don’t want to wait until April 1 to get the ball rolling. “

And, of course, with a 401 (k) loan, you will lose any tax-deferred income that you would have had if you hadn’t borrowed from the plan. “You probably won’t see the growth in your 401 (k) like you would have seen without the loan,” Meadows said. “More money makes more money.”

A 401 (k) loan also tends to cause some borrowers to lower their retirement savings rate. Loyalty found that about one in four employees who take 401 (k) loans decrease their savings rate in the plan in the first year they receive the loans, including 9% who stop contributing altogether. Remember, too: Lowering your 401 (k) pre-tax contributions could mean a higher tax bill that year.

An alternative: IRS installment agreements

Barbara Weltman, editor of Your 2016 income tax from JK Lasser, don’t like to use a 401 (k) to pay your taxes. “Your 401 (k) should be your retirement money, ”she said.

Weltman thinks a better alternative if you’re strapped for cash is to get an installment agreement with the IRS to pay your taxes (Form 9465).

Anyone who owes $ 50,000 in taxes, penalties and interest and who has filed a return can apply; some people are eligible if they owe less than $ 100,000. And you are guaranteed approval if you owe less than $ 10,000; have filed your returns on time within the past five years and agree to pay the full amount you owe within three years.

“If you owe less than $ 10,000, you can usually complete the contract online and set it up as an automatic payment plan from your bank account, ”Weltman said. “The IRS interest rates on installment agreements are so low,” she added. You’ll pay the short-term federal rate plus 3% – today, around 4%.

There is no setup fee if you qualify for a short-term IRS installment agreement of 120 days or less; otherwise, you will owe the IRS $ 43 to $ 120, depending on your income and whether you have the money debited from your bank account.

Whatever you decide to do to find the money, make sure you file your tax return on time and pay Something when you do. Otherwise, the IRS will issue you a late filing penalty (5% of additional taxes owed for each month your return is late, up to 25%) and a late payment penalty (1/2 of 1% of your amount. outstanding payment). taxes for each month of delay).

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