When Congress developed the 401k in 1978, it included language that allowed plan sponsors to let workers borrow money from their 401k plans. This accomplished a couple of congressional objectives: It provided workers with a reasonable source of short- to mid-term capital to deal with personal emergencies. And it short-circuited an argument against contributing: The drafters of the law were concerned that if there were no provision for accessing that capital in a emergency, workers would simply not contribute to the plans.
The 401k was introduced as part of the Internal Revenue Code in 1978. Originally, it was conceived as a salary deferral program that allowed workers and executives to defer a portion of their income for retirement without paying taxes on the contribution. The plan proved enormously popular, thanks to the tax benefits of deferring income tax on a substantial amount of money -- far outstripping the available contribution limits in IRAs at the time. The 401k also allowed for company matching funds on worker contributions, further enhancing the program's popularity. They were also popular with employers because they were far less expensive to maintain than traditional defined benefit pension plans.
Tax Treatment of 401k Accumulation
The worker does not take direct receipt of 401k contributions. Instead, they are deducted from the worker's paycheck and forwarded to the investment custodian. No federal taxes are paid out of the contribution. The proceeds grow tax-deferred, and withdrawals after age 59 1/2 are taxed at ordinary income rates. Starting in the year in which you turn 70 1/2, you must begin taking withdrawals -- and paying taxes on those withdrawals. Otherwise the IRS charges a penalty of half of the amount you were supposed to withdraw.
Tax Treatment of Withdrawals
Generally, the IRS charges a 10 percent penalty on amounts withdrawn from a 401k plan before age 59 1/2, though some exceptions apply: If you leave your employer after age 50, or if withdrawals are due to disability, to pay medical bills, to avoid foreclosure or eviction, to make a down payment of up to $10,000 on a home for yourself or a family member, to pay college expenses for yourself or a family member, or if you take "substantially equal periodic payments" under Section 72(t) of the U.S. Tax Code.
Some plans allow workers to borrow from their 401k plans, but not all. If your plan allows you to take a loan, there is no tax due on the amount borrowed. You generally have up to five years to pay back the money. If you fail to pay the loan, the IRS deems the loan to be a taxable distribution and will charge income tax on the amount borrowed. If you are under age 59 1/2, the 10 percent penalty will also apply. If you leave your employer for any reason during the term of the loan, you must repay the loan immediately or the IRS will consider the loan to be a taxable distribution.
There are a couple of things to consider when taking a 401k loan: You should be confident that you will remain with your employer for the life of the loan. Also, you should understand that you are essentially taking money out of an investment that accumulates tax-deferred and placing it into an instrument that, in most cases, generates tax liabilities in the form of income taxes or capital gains. The rate of return in the investment outside the 401k should more than compensate you for the risk of incurring a penalty and paying taxes.