Can I Take Out a Loan on My 401(k)?

A 401(k) loan allows participants to borrow directly from their vested retirement savings, without involving traditional credit checks or affecting credit scores. Unlike a withdrawal, the money borrowed is a loan against your own accumulated savings. The principal and interest paid on the loan are returned to your 401(k) account. While providing a source of funds, these loans are governed by specific Internal Revenue Service (IRS) regulations and individual plan rules, which dictate how much can be borrowed and under what terms.

Eligibility and Loan Limits

Accessing a 401(k) loan depends on whether the specific retirement plan offers a loan provision, as plan sponsors are not required to include this feature. If allowed, typical eligibility requires being an active employee with a vested account balance. Some plans may also impose a minimum account balance. Consult your plan’s summary description or contact the plan administrator for precise eligibility details.

The amount a participant can borrow is subject to limits set by the Internal Revenue Code Section 72(p). The maximum loan amount is generally the lesser of $50,000 or 50% of the participant’s vested account balance. An exception allows borrowing up to $10,000 if 50% of the vested balance falls below this amount. For example, if your vested balance is $15,000, you could borrow up to $10,000, provided the plan allows this exception.

Previous outstanding loans affect current borrowing capacity. The $50,000 limit is reduced by the highest outstanding balance of any prior loans from the plan within the preceding 12 months. This calculation ensures that the aggregate borrowing across a year does not exceed the statutory maximum. Plans may also impose their own lower limits or restrict the number of active loans a participant can have simultaneously.

Repayment and Interest

Repaying a 401(k) loan typically involves a structured schedule, with a standard five-year repayment period. An exception applies if loan proceeds are used to purchase a primary residence, allowing for a longer term, often up to 15 or 30 years, depending on the plan. Payments are generally required at least quarterly, ensuring consistent amortization.

The interest rate charged on a 401(k) loan is usually tied to the prime rate, often plus an additional 1% or 2%. This rate is determined by the plan and must be reasonable. Interest paid by the borrower is not collected by an external financial institution; instead, it is repaid directly back into the participant’s own 401(k) account. This means the interest accrues to the benefit of the borrower’s retirement savings.

Repayment of 401(k) loans is most commonly through regular payroll deductions. This automated method helps ensure timely payments and reduces default risk. Payroll deductions are made with after-tax dollars, meaning the money used for repayment has already been taxed. While a loan is outstanding, some plans might restrict new contributions to the 401(k) account, though this varies by plan.

Application Process

Initiating a 401(k) loan request typically begins by contacting your plan administrator, Human Resources department, or accessing the plan’s online portal. This step confirms loan availability and provides access to specific terms and conditions. Many plans facilitate the application process online, allowing participants to check eligibility and restrictions directly.

The application process requires completing specific forms from the plan administrator. These forms outline the necessary information for the loan request. Once submitted, the plan administrator reviews the application to confirm eligibility and adherence to plan rules and IRS guidelines. This review typically takes one to five business days, but can be longer if additional documentation is needed, such as for a primary residence loan.

Upon approval, loan proceeds are disbursed to the participant, commonly via direct deposit or check. Direct deposits often take two to three business days after processing, while checks may take 7-10 business days. The participant will also receive confirmation notices and details regarding the repayment schedule, including payroll deduction amounts and frequency.

Understanding Loan Default

A 401(k) loan default occurs when a participant fails to adhere to the agreed-upon repayment terms, including missing scheduled payments or failing to repay the loan in full by the deadline. Plans often provide a grace period, sometimes extending until the end of the calendar quarter following the missed payment, before a loan is officially considered in default.

The primary consequence of defaulting on a 401(k) loan is that the outstanding balance is treated as a taxable “deemed distribution” by the IRS. This is known as a “deemed distribution.” The full unpaid loan amount is considered taxable income for the year of default. In addition to regular income taxes, if the participant is under age 59½ at the time of the deemed distribution, an additional 10% early withdrawal penalty typically applies, unless an exception is met.

Defaulting on a loan also has implications for future plan participation; some plans may prohibit new loans. A significant risk occurs if employment ends while a loan is outstanding. The full outstanding loan balance often becomes due almost immediately, or within a short grace period, usually by the tax return due date of the following year. Failure to repay by this accelerated deadline results in a deemed distribution, triggering the same tax and penalty consequences.