Can I Take a Loan Out Against My 401k?

A 401(k) plan is an employer-sponsored retirement savings account designed with tax benefits to help individuals save for their future. Money contributed to a 401(k) can be invested and potentially grow over time in a tax-advantaged manner, either pre-tax in a traditional 401(k) or after-tax in a Roth 401(k). While these plans are primarily for retirement, some allow participants to borrow against their accumulated savings.

Eligibility and Plan Availability

Not all 401(k) plans permit loans; the decision to offer this feature rests with the employer. If a plan offers loans, it must outline the procedures for applying and repayment terms. Individuals can determine if their plan offers loans by consulting their human resources department or the plan’s Summary Plan Description.

Even when allowed, participants must meet eligibility requirements. A participant must be an active employee to be eligible for a loan. The ability to borrow is tied to the participant’s vested account balance, which is the portion of the account that fully belongs to them. Employee contributions are always 100% vested, but employer contributions may have a vesting schedule, meaning they become fully owned over a set period of employment.

Understanding Loan Mechanics and Repayment

A 401(k) loan involves borrowing money directly from a participant’s own retirement savings account, rather than from a third-party lender. The amount that can be borrowed is subject to federal limits established by the IRS, which cap the loan at 50% of the vested account balance or $50,000, whichever is less. If 50% of the vested balance is less than $10,000, a participant may be able to borrow up to $10,000. Plan administrators may also set lower limits than the federal maximums.

Repayment terms for 401(k) loans are structured with a maximum period of five years for most purposes. An exception exists for loans used to purchase a primary residence, which may allow for a longer repayment period, up to 15 years. Loan repayments, including both principal and interest, are made through regular payroll deductions. The interest rate charged on a 401(k) loan is often the prime rate plus one or two percentage points, and this interest is paid back into the participant’s own 401(k) account, rather than to an external lender.

Key Implications of Borrowing

Borrowing from a 401(k) carries implications concerning taxes and the long-term growth of retirement savings. As long as the loan is repaid according to the established terms, it is not considered a taxable event, meaning no immediate income tax is due on the borrowed amount. If the loan is not repaid on schedule, the outstanding balance is treated as a taxable distribution, and income taxes become due. Additionally, if the participant is under age 59½, an early withdrawal penalty of 10% applies to the defaulted amount, on top of the regular income tax.

A consequence of taking a 401(k) loan is the potential impact on retirement savings growth due to missed investment opportunities. The funds borrowed are temporarily removed from the investment portfolio, meaning they do not participate in any market gains during the loan repayment period. Some plans might also restrict further contributions to the 401(k) until the loan is repaid, which could mean missing out on employer matching contributions.

Leaving employment, whether voluntarily or involuntarily, accelerates the repayment terms of an outstanding 401(k) loan. The full outstanding loan balance typically becomes due by the tax filing deadline of the following year. If the loan is not repaid within this shortened timeframe, the unpaid balance is treated as a “deemed distribution” from the plan, making it subject to income tax and the potential 10% early withdrawal penalty if the individual is under age 59½. While defaulting on a 401(k) loan does not affect one’s credit score, it can result in a reduction of retirement savings and an unexpected tax liability.