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Many plans also allow employees to take loans from their 401(k) to be repaid with after-tax funds at pre-defined interest rates. The interest proceeds then become part of the 401(k) balance. The loan itself is not taxable income nor subject to the 10% penalty as long as it is paid back in accordance with section 72(p) of the Internal Revenue Code. This section requires, among other things, that the loan be for a term no longer than 5 years (except for the purchase of a primary residence), that a "reasonable" rate of interest be charged, and that substantially equal payments (with payments made at least every calendar quarter) be made over the life of the loan. Employers, of course, have the option to make their plan's loan provisions more restrictive. When an employee does not make payments in accordance with the plan or IRS regulations, the outstanding loan balance will be declared in "default". A defaulted loan, and possibly accrued interest on the loan balance, becomes a taxable distribution to the employee in the year of default with all the same tax penalties and implications of a withdrawal. These loans have been described as tax-disadvantaged, on the theory that the 401(k) contains before-tax dollars, but the loan is repaid with after-tax dollars. This is not correct. The loan is repaid with after-tax dollars, but the loan itself is not a taxable event, so the "income" from the loan is tax-free. This treatment is identical to that of any other loan, as long as the balance is repaid on schedule. (A residential mortgage or home equity line of credit may have tax advantages over the 401(k) loan; but that is because the interest on home mortgages is deductible, and unrelated to the tax-deferred features of the 401(k).)

Includes CC-BY-SA content from Wikipedia's 401(k) article (authors)

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