As Tax Day approaches (April 18 in most places this year), you may be looking at a whopper of a tax bill and wondering where you’ll find the money to pay it.
And then you might think: Hmmm, I have some money sitting in my 401(k). Maybe I should take out a 401(k) loan to write a check to the IRS….
About 90 percent of 401(k) participants are able to borrow against their balance and roughly 11 percent do each year. By contrast, you can’t borrow against an Individual Retirement Account. So should you take out a 401(k) loan for your taxes? Maybe.
Easy Access Without Financial Jeopardy
“A 401(k) loan is a really easy way to get access to cash without putting yourself in financial jeopardy,” says Andrew Meadows, the San Francisco-based vice president of brand and culture at Ubiquity Retirement + Savings which handles small business retirement plans.
A 401(k) loan is a really easy way to get access to cash without putting yourself in financial jeopardy.
— Andrew Meadows, Ubiquity Retirement + Savings
That’s because taking out a 401(k) loan isn’t like a traditional bank loan.
For instance, there’s no credit check, and getting the loan doesn’t affect your credit score; applying for a standard loan could lower your credit score by 5 to 10 points because the new application for credit appears on your credit report.
With a 401(k) loan, you’re just paying interest back to yourself, generally automatically from your paycheck. As a rule, you have to repay the loan within five years.
How Much You’ll Pay for a 401(k) Loan
Typically you pay an interest rate on a 401(k) loan that’s equal to a percentage point or two above the prime rate, which would currently mean between 4.5 and 5.5 percent. By contrast, putting your taxes on your credit card bill could sock you with an interest rate of 15 percent or so.
And unlike a 401(k) withdrawal — if you can get your employer to let you have one — you usually won’t incur any income taxes or tax penalties with a 401(k) loan.
Due to these advantages, “we often see an uptick in 401(k) loan requests around tax time by small-company owners and individual contract employees who’ve set up solo 401(k) plans,” said Meadows. “Their tax bills can be quite enormous.”
Drawbacks to 401(k) Loans
Now the downsides to 401(k) loans:
There’s a limit to how much you can borrow — no more than 50 percent of your vested account balance or $50,000, whichever is less. One exception: if your 401(k) has less than $20,000, you may be able to borrow up to $10,000.
Another drawback: If you leave your employer before your 401(k) is paid off, you’ll need to either come up with the rest of the cash within 60 days or face a tax bill, because the IRS will view the outstanding loan as a taxable distribution. If you’re under 55, that’ll mean paying ordinary income tax on the money and probably a 10 percent penalty.
Also, it can take about a month to get your hands on the money once you apply for a 401(k) loan. So you’ll likely need to ask for one by early- or mid-March to ensure you’ll have the funds when your tax return is due. “It can be a bit of an administrative nightmare,” said Meadows. “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’ll miss out on any tax-deferred earnings you would’ve had if you hadn’t borrowed from the plan. “You probably won’t see the growth in your 401(k) as you would have seen without the loan,” said Meadows. “More money makes more money.”
A 401(k) loan also tends to lead some borrowers to cut back on their retirement savings rate. Fidelity found that about one in four employees who take out 401(k) loans decrease their savings rate in the plan during the first year they have the loans, including 9 percent who stop making contributions altogether. Remember, too: lowering your pretax 401(k) contributions could mean owing a higher tax bill that year.
An Alternative: IRS Installment Agreements
Barbara Weltman, an editor of J.K. Lasser’s Your Income Tax 2016, is not a fan of using 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 short on 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 has filed a return can apply; some people qualify if they owe under $100,000. And you’re guaranteed approval if you owe less than $10,000; have filed your returns on time during 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 generally fill out the agreement online and set it up as an automatic payment plan from your bank account,” Weltman said. “IRS interest rates on installment agreements are so low,” she added. You’ll pay the federal short-term rate plus 3 percent — today, about 4 percent.
There’s no setup fee if you qualify for a short-term IRS installment agreement of 120 days or less; otherwise, you’ll 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 come up with the cash, be sure you file your tax return on time and pay something when you do. Otherwise, the IRS will slap you with a late-filing penalty (5 percent of the extra taxes owed for each month your return is late, up to 25 percent) and a late-payment penalty (1/2 of 1 percent of your unpaid taxes for each month you’re late).