Can I Take a Loan Against My 401(k)?

A 401(k) loan allows individuals to borrow from their vested retirement savings rather than from a traditional lender. This means the individual is essentially borrowing money from their own account, and no credit check is required for approval. Unlike a withdrawal, which permanently removes funds and may incur taxes and penalties, a loan requires repayment, with the borrowed funds and interest returning to the account. This mechanism can offer a way to access funds without permanently diminishing retirement savings, provided the loan is repaid as stipulated.

Understanding Loan Eligibility and Amounts

Not all 401(k) plans offer a loan feature; it is determined by the plan administrator or employer. Individuals must confirm their specific 401(k) plan permits loans and review its provisions. Eligibility generally extends to active employees whose plans allow for such borrowing.

The maximum amount an individual can borrow from their 401(k) is governed by Internal Revenue Service (IRS) regulations. The loan amount cannot exceed the lesser of $50,000 or 50% of the participant’s vested account balance. For instance, if an individual has a vested balance of $75,000, the maximum loan would be $37,500 (50% of $75,000), as this is less than $50,000. Some plans may allow a loan of up to $10,000 if 50% of the vested balance is less than that amount.

When calculating the $50,000 limit, a look-back rule applies if the individual has had other outstanding 401(k) loans within the past 12 months. The maximum loan amount is reduced by the highest outstanding loan balance during that preceding 12-month period. For example, if someone had a $25,000 loan outstanding at any point in the last year, their current maximum borrowing capacity would be $50,000 minus that $25,000, leaving $25,000, assuming their account balance supports it. This ensures that the total borrowing from the plan over a short period does not exceed the regulatory limits.

Some plans may also impose a minimum loan amount, such as $1,000. A plan may also have rules regarding the number of outstanding loans an individual can have at any given time. While IRS rules primarily focus on the maximum dollar amount, plan documents dictate whether multiple loans are permissible.

Loan Repayment Rules and Application Steps

The repayment period for a 401(k) loan is typically limited to a maximum of five years. An exception exists for loans used to purchase a primary residence, which may allow for an extended repayment period, potentially up to 15 years, depending on the plan’s specific provisions. The loan terms, including the repayment schedule, are established at the time the loan is originated.

Repayments are usually made through regular payroll deductions. These payments must include both principal and interest and are generally required at least quarterly. The interest rate for a 401(k) loan is typically determined by the plan administrator, often based on the prime rate plus an additional percentage, such as one or two percentage points.

A distinct feature of 401(k) loans is that the interest paid on the loan goes back into the participant’s own retirement account, contributing to the growth of their retirement savings. Some plans may also charge administrative fees for processing the loan, which could include a one-time setup fee, often ranging from $50 to $100, or annual maintenance fees.

To apply for a 401(k) loan, review the specific plan documents to confirm loan availability and understand the procedures. Individuals then contact their plan administrator or recordkeeper to initiate the process. This usually involves completing a loan application form, outlining the proposed loan amount, repayment terms, and other necessary details. Once approved, the funds are disbursed to the participant.

What Happens with Unpaid Loans or Job Changes

A 401(k) loan is considered in default if payments are not made according to the established repayment schedule. When a loan defaults, the outstanding balance is typically treated as a “deemed distribution” from the 401(k) plan.

The immediate consequence of a defaulted loan is that the outstanding balance becomes subject to taxation. It is treated as ordinary income for the year of default. If the participant is under age 59½, the defaulted amount may also be subject to a 10% early withdrawal penalty imposed by the IRS. This dual impact of income tax and potential penalty can significantly reduce the amount of money available for retirement and result in an unexpected tax liability.

Changing employment can also significantly impact an outstanding 401(k) loan. Many plans require the full repayment of the loan balance within a relatively short period after job separation. This repayment period is often 60 to 90 days following the termination date, though plan specifics can vary.

If the loan is not repaid by this accelerated deadline, the outstanding balance is again treated as a taxable distribution, incurring income tax and potentially the 10% early withdrawal penalty. However, with a “qualified plan loan offset” (QPLO), individuals may have until the tax return due date, including extensions, for the year of the offset to roll over the defaulted amount into another eligible retirement plan, such as an IRA, to avoid immediate taxation and penalties.