401k loans: What you need to know

Borrowing from your 401(k) may be an option if your plan allows it. While a 401(k) loan can be an easy source of money, the funds borrowed are not making money as an investment while the loan is outstanding. Additionally, if you fail to pay back the loan it can become a taxable distribution and potentially be subject to a penalty as well.

If you are considering this as an option it’s important that you understand how 401(k) loans work, as well as the pros and cons.

Can you borrow from your 401(k)?

The answer to this question depends on whether or not your employer’s 401(k) plan allows you to borrow from it. Allowing plan loans is not mandatory and a plan sponsor may choose not to offer them. Reasons may include not wanting to deal with the administration of the loans and concerns that too many participants will take loans, potentially harming the borrower’s ability to accumulate enough money for retirement.

How much can you borrow from your 401(k)?

The IRS limits 401(k) plan loans to 50% of your plan account balance or $50,000, whichever is less. They offer an exception to this limit if the vested amount in the account is less than $10,000. In this case the plan participant may borrow up to $10,000 from their 401(k) account. Plans are not required to include this exception, however. Additionally, each plan can set their limits on the amount that can be borrowed as long as they stay within the IRS limits. 

How does a 401(k) loan work?

If your employer’s plan allows loans, you may borrow against your account up to the limits set by the plan. A 401(k) is not a loan in the truest sense. There is no credit check and you are essentially borrowing from yourself.

There is an interest rate and a repayment schedule. The money received from the loan serves to reduce the balance in your 401(k) plan. The money withdrawn does not participate in any growth experienced by the money remaining in your account. This can be a setback as you seek to accumulate enough for a comfortable retirement.

Repayment of principal plus any interest paid all goes back into your account. You are repaying yourself, not your employer.

If you default on repayment or if you leave your employer prior to fully repaying the loan, the remaining loan amount could become classified in the eyes of the IRS a taxable distribution. In this situation you could be subject to an early withdrawal penalty, and you would have to pay tax on the money you borrowed as if it were income.

Changes in the rules in recent years have allowed employers to extend loan repayment terms to employees who leave the company for a longer period than in the past. Prior to taking out a 401(k) loan, it is critical that you understand how repayment works whether you remain with the company until the loan is fully repaid or if you leave prior to that time.

When should you borrow from your 401(k)?

You generally should not borrow small amounts from your 401(k) on a frequent basis. Rather, you should choose a situation where you have a serious short-term cash need. In this type of situation your 401(k) can be a viable source of funds.

A serious cash need might be some sort of financial emergency. In a case like this, borrowing from your 401(k) might be the quickest source of a significant amount of cash. There are no credit checks and you are borrowing your own money.

As long as you can repay the loan based on the schedule from your employer, the overall impact on your financial situation can be minimal. However, if you know in advance that you won’t be able to repay the funds, you will need to think through the repercussions of defaulting on the loan before going ahead with this process.

Pros and cons of a 401(k) loan

There are both pros and cons to a 401(k) loan.

Pros

• A 401(k) loan is a way to tap into your 401(k) balance without incurring taxes or penalties. Further, plan sponsors typically do not allow in-service withdrawals except for hardships.
• Unlike most lenders, there are no credit checks when taking a 401(k) loan. This can be a key advantage if you need cash and have a low credit score.
• Interest and principal payments are made to your account versus being paid to a third-party lender.
• Interest rates are often lower than on alternatives like personal loans and other borrowing options.

Cons

• A 401(k) loan removes funds from your 401(k) account. This money grow as an investment while it is out of the account.
• If you leave the company before the loan is fully repaid this can trigger a situation where the remaining loan balance is treated like a distribution from the plan resulting in taxes and possible penalties. This will not occur in all cases as more companies are allowing loan repayment periods after participants leave the company.
• Some companies may not allow you to contribute to the 401(k) plan while you have a plan loan outstanding. During this period you can’t increase your retirement savings and you will miss out on any matching contributions from your employer if they match employee contributions.

How to borrow from your 401(k)

You will generally need to apply via your plan’s administrator. The administrator may be someone internal at your employer or an outside administrator. In most cases you can do this on the plan’s website.

401(k) loan alternatives

There are alternatives to a 401(k) loan if you need to raise some cash. Whether any of these options are right for you will depend upon your personal circumstance.

• A home equity loan might be an option if you have equity in your home to tap. If you need the cash for home repairs or home improvements this option can be attractive as the interest on the loan may be tax deductible.
• A 0% or low interest rate balance transfer card is another potential option. If you have good credit and can repay the outstanding balance within the promotional period this can be an option to consider.
• A hardship plan withdrawal. This allows you to take a taxable withdrawal from the plan. You may qualify for an exemption from the normal 10% penalty on early withdrawals. There are disadvantages to hardship withdrawals, so do your research on how they work before going this route.
• A personal loan can be used for most purposes and is unsecured, meaning there is no collateral required. Loan amounts up to $100,000 or more may be available. The amount you can borrow and your interest rate will be tied to your credit score.

Frequently asked questions (FAQs)

What happens if you leave your job?

If you leave your job prior to having paid off the loan, it will become due and payable. The time frame after leaving your job will vary by company. In some cases it will be due immediately or within a very short time. In other cases you may have a bit longer, generally until the tax filing due date including any extensions for the tax year in which you leave your job.

Failing to pay back any part of the loan will result in that portion being treated as a taxable distribution. It could also trigger a 10% penalty if you are younger than age 59 ½. 

How long do you have to repay a 401(k) loan? 

The repayment term on a 401(k) loan is generally five years. If the loan is for the purchase of a principal residence, the term might be as long as 25 years. The repayment terms can vary from plan to plan, so it is always best to check with your plan’s administrator on loan terms and rules, including the repayment terms. 

Can you pay off a 401(k) loan early?

Loans can be paid off early with no prepayment penalty. Loan payments are usually made by payroll deduction just like plan contributions. You will need to make arrangements with your plan administrator to increase your payments if you are looking to pay them off early.