401(k) Loan Rules to Know
At some point in your life, you’ll need to borrow money whether for a new home, college tuition, medical bills, or even launching a new business. The good news is you can choose from several lending options to do so: banks, credit unions, credit cards, peer-to-peer lending platforms, family, or friends. One additional option? Borrowing money from your 401(k).
Before you take the plunge, however, it’s important to learn how 401(k) loans work and the pros/cons of going this route—which is precisely what we’ll cover in this post.
How 401(k) loans work
When you take out a 401(k) loan, you’re borrowing money from your own retirement savings using your vested account balance as collateral. Your plan administrator will determine the maximum amount you can borrow—typically up to 50% of your vested balance, with a maximum cap of $50,000—and set the interest rate, usually based on the current prime rate (often making 401(k) loans more affordable than other options). As you repay the loan, then, both the principal and interest go back into your retirement account so you pay yourself rather than a bank or outside lender.
How much you can borrow from your 401(k)
By law and as just mentioned, the maximum amount you can borrow from your 401(k) is typically 50% of your vested account balance or $50,000 (whichever is less). If your vested balance is $50,000, for example, you can borrow up to $25,000 with loan amounts ultimately varying depending on your vested balance and specific 401(k) plan rules. Be sure to carefully review your plan documents to understand exactly how much you can borrow.
Repaying your 401(k) loan
401(k) loan repayment terms are generally straightforward: you’re required to repay the loan, plus interest, within five years. Many plans may allow a longer repayment period (often up to 10 years) if you use the loan to purchase a primary residence.
Monthly payments are typically set up via payroll deductions—making it easier to stay on track—with the amount of your monthly payment depending on the loan amount, interest rate, and length of your repayment term. Review your plan’s specific repayment terms to make sure you can comfortably afford the monthly payments.
Failing to repay your 401(k) loan
Missing payments or failing to repay your 401(k) loan on time can have serious consequences, with the outstanding loan balance considered a deemed distribution if you don’t meet the repayment terms—treating it as a withdrawal and counting it as taxable income for that year. Those under age 59½ are subject to a 10% early withdrawal penalty.
Advantages of borrowing from a 401(k)
Taking out a 401(k) loan has several benefits in comparison to other types of debt:
Convenience
A quick phone call (or clicks on a website) is often all that’s needed to receive funds within a few days, depending on your plan administrator. Many companies have also begun to offer a 401(k) debit card that deducts money directly from your account. Loan payments are typically deducted from your paycheck, making repayment easy.
No credit reporting
A credit check isn’t required when applying given the lack of underwriting, and a 401(k) loan won’t appear as debt on your credit report. 401(k) loans aren’t reported to credit bureaus, meaning you won’t damage your credit score if you miss a payment or default on your loan.
Lower interest rates
The amount of interest you pay is set by your plan’s administrator and based on prime (the interest rate banks use to charge customers with good credit). The 401(k) rate is typically lower than those of alternative sources, making payments more affordable.
Interest payments
With a traditional loan, you pay interest to a financial institution. With a 401(k) loan, however, the interest you pay goes right back into your own account.
Payment flexibility
You have five years to repay your loan (or up to 10 years when the money is used to purchase a principal residence) and face no prepayment penalties.
Suspended and/or extended payments
Those in the armed forces can sometimes suspend loan repayments and/or extend the term if called up for active duty.
Drawbacks of borrowing from a 401(k)
On the flip side, taking out a 401(k) loan also involves several risks. These include:
Missed investment growth
When you take out a 401(k) loan, that money is no longer invested; you may therefore potentially miss out on significant investment returns and potential retirement savings growth, especially during a bull market.
If you leave your job, you’ll need to pay back your loan more quickly
Whether you leave your job voluntarily or otherwise, you may be required to pay back your loan within 60 days (check your specific plan rules).
Defaulting can trigger taxes
If you can’t repay your loan due to missed payments, your unpaid loan balance is considered a “deemed distribution”—adding your unpaid balance to the gross income you’d pay taxes on for that same year. The IRS may also tax you and assess a 10% penalty if you’re under age 59½.
You may not get approved
Employees nearing retirement are sometimes considered “higher risk” and thus denied a 401(k) loan since payments will no longer come out of their paychecks on an automatic basis. Other reasons for a possible denial include exceeding your loan limit or if your motivation for seeking the loan fails to meet plan criteria (e.g., if you want to finance your next vacation).
401(k)s from previous employers aren’t in play
Unless you rolled over money from previous 401(k)s, you can only borrow money from your current 401(k) plan.
You may contribute less
After obtaining a 401(k) loan, it’s not uncommon for plan participants to scale back their regular contributions; some employers don’t allow for contributions while participants have an outstanding loan, meaning you can also miss out on employer matches.
Potential fees
In addition to interest, your employer may charge application fees along with a monthly (or annual) maintenance fee.
As you can see, borrowing from a 401(k) unfortunately has many drawbacks—which is precisely why you should only consider borrowing from your 401(k) as a last resort.
How to obtain a 401(k) loan
1. Check your 401(k) plan for eligibility
Start by confirming whether your 401(k) plan allows loans. While over 90% of plans do, each one has specific provisions and rules. Review your employer’s plan documents or speak with your plan administrator for more details.
2. Gather loan details
While most employers permit 401(k) loans for any reason, always verify your plan’s specific guidelines and loan application details with HR or your plan administrator.
3. Decide how much to borrow
Calculate the amount you plan to borrow based on your financial needs and the maximum your 401(k) plan allows.
401(k) loan alternatives
401(k) loan alternatives exist beyond checking, savings, and brokerage accounts.
For example, home equity loans or lines of credit are low-cost options—especially if you plan to use the funds to finance much-needed home repairs, with the interest often tax-deductible in both cases. You can also take out a personal loan to enjoy quick access to funds for any personal expense, shopping around for the best deal if you decide to go this route (as with any loan).
Health savings account (HSA), meanwhile, can help cover qualified out-of-pocket healthcare expenses including deductibles and copays. A low or zero-rate credit card is a viable alternative as well, provided you can repay your balance within the promotional period (typically ranging from six to 18 months, depending on the issuer). Retirement plans (e.g., IRAs) usually offer several withdrawal options—including loans and hardship withdrawals—depending on your situation.
401(k) loan vs. 401(k) withdrawal: What’s the difference?
A 401(k) loan and a 401(k) withdrawal are two different ways to access your retirement funds, each with different implications. For example, a 401(k) loan lets you borrow from your account and pay it back (typically with interest) over a set period. If you meet the repayment schedule, you generally avoid immediate taxes and penalties.
In contrast, a 401(k) withdrawal permanently removes money from your account: typically resulting in income taxes and an early withdrawal penalty (10% of the amount withdrawn) for those under age 59½. When repaid as agreed, a 401(k) loan can help you maintain your long-term retirement savings—whereas a 401(k) withdrawal directly reduces your retirement balance with the potential for significant long-term financial repercussions.
In sum: Is taking out a 401(k) loan a good idea?
Contemplating whether to take out a 401(k) loan is a decision to not take lightly, with the risks generally outweighing the benefits. That’s not to say this option never makes sense, however, a 401(k) loan often the right move for those well on their way toward a financially secure retirement or needing the money for a short-term expense (for example).
Want to know if a 401(k) loan is right for you? Schedule a free consultation with one of our CFP® professionals to learn more.
FAQs
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It all depends on your specific plan’s rules, so check with your administrator to learn if simultaneous loans are permitted.
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Each plan has different rules on 401(k) loans and withdrawals. That said, you must generally take out a second loan (if permitted) on your 401(k), roll over your plan into a new one (if changing jobs), or roll over your 401(k) into an IRA to gain access to additional funds.
With respect to either rollover option, so long as your loan repayment is in good standing, your employer will roll over your net retirement funds of the outstanding 401(k) loan via a “loan offset.” If you successfully roll over this amount by the tax-filing deadline for the year in question, you can avoid paying income taxes and a 10% early withdrawal penalty on the rolled-over balance.
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Taking money out of your 401(k) for what the IRS deems an “immediate and heavy financial need” is referred to as a “hardship withdrawal.”
Such needs include avoiding foreclosure or eviction, repairing casualty losses to a principal residence (such as those from floods, earthquakes, or fires), home-buying expenses for a principal residence, burial or funeral expenses, up to 12 months’ worth of tuition and fees, and some medical expenses; your employer has discretion here in most situations.
Hardship withdrawals are generally more difficult to qualify for given the need to prove a lack of alternative funding options, but unlike with a 401(k) loan, you don’t need to repay these funds (though you’re still required to pay taxes on them).
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This is indeed possible because these loans don’t require a credit check and aren’t reported to credit bureaus, so missing a payment (or even defaulting on your 401(k) loan) won’t affect your credit score. It’s important to remember, however, that defaulting can have significant tax consequences and impact your retirement savings.
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This process is pretty straightforward; if your plan allows loans, you’ll usually need to contact your plan administrator and complete a simple application process (either by phone or online).
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Yes, your employer will be privy to this since companies set the rules for the 401(k) program and you’ll need to go through them (generally your HR department) to apply.
About the author
The content in this post was developed by our team of writers and reviewed by our team of CFP® professionals here at Vision Retirement.
Retirement Planning | Advice | Investment Management
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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. Schedule a no-obligation consultation with one of our financial advisors today!
Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.
