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Are 401(k) loans taxed?

October 1, 2012: 6:30 AM ET

If I borrow from my 401(k), do repayments come out of after-tax or pre-tax dollars? If they come from after-tax dollars, is the money taxed when withdrawn a second time? — Joe C.

Your repayment of a 401(k) loan does come from after-tax dollars, and when you eventually withdraw those funds in retirement, they will be taxable as regular income. But this doesn't represent a second round of taxes. That's because you aren't paying taxes or penalties on the amount you borrow in the first place. "That's one of the advantages of borrowing money from your 401(k)," says Jean-Luc Bourdon of BrightPath Wealth Management in Santa Barbara, Calif.

Consider it this way: Your contributions originally were made with pre-tax dollars. The tax on those contributions are deferred until you begin making withdrawals after age 59 ½. When you borrow from and repay funds to your 401(k), there's no change to the qualified status of those funds: They will still be subject to tax when they are ultimately withdrawn. "It's as if it was never withdrawn in the first place — just borrowed and repaid," says Bourdon.

Be aware, however, that not all 401(k) plans allow you to take out a loan, and that loans are typically limited to 50% of your plan assets or $50,000, whichever is lower. The loan also must typically be repaid within five years. Bourdon warns that if you don't repay your loan on time, the unpaid portion will be treated as a taxable distribution, and you may face an additional early-withdrawal 10% penalty if you are younger than 59 ½.

— Austin Kilham

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