Can You Borrow From a 401(k)?

A 401(k) plan is an employer-sponsored retirement savings account that allows employees to contribute a portion of their income. Though designed for retirement savings, individuals may need to access funds earlier. Under specific conditions, it is possible to borrow money from a 401(k) plan. This article explains 401(k) loans, including eligibility, function, limits, repayment, and tax implications.

Understanding 401(k) Loan Eligibility

Eligibility for a 401(k) loan begins with the specific plan itself, as not all plans offer this feature. The decision to permit loans rests with the plan administrator, who defines the criteria and terms. Participants must consult their plan documents or human resources department to confirm if loans are an option.

Common requirements for participants typically include being an active employee. Most plans offering loans are designed for those currently employed, which facilitates repayment through payroll deductions. Participants must also have a vested balance in their account, meaning they own their contributions and any employer contributions that have met the plan’s vesting schedule.

Some plans may also stipulate a minimum account balance to qualify for a loan. While specific amounts vary, this helps ensure sufficient funds are available. Additionally, plans might have rules regarding the purpose of the loan, though many allow loans for general purposes. It is crucial to review the individual plan’s rules, as these can differ significantly from one employer to another.

Mechanics of a 401(k) Loan

When an individual takes a 401(k) loan, they are borrowing money from their own vested account balance, not from an external lender. This means the funds come directly from the participant’s retirement savings, which are then temporarily removed from investment. The loan is typically secured by the participant’s 401(k) balance.

Interest is charged on 401(k) loans, but this interest is paid back into the participant’s own 401(k) account, rather than to the employer or a third-party financial institution. This structure means the interest payments help to replenish the participant’s retirement savings over time. The interest rate is usually set by the plan and is often competitive with, or lower than, rates for other types of personal loans.

Repayment of a 401(k) loan is most commonly facilitated through regular payroll deductions. This method ensures consistent payments and helps participants adhere to the repayment schedule. Payments are typically made on a predetermined frequency, such as weekly, bi-weekly, or monthly, aligning with the payroll cycle.

Loan Limits and Repayment Obligations

Federal regulations establish limits on the amount that can be borrowed from a 401(k) plan. A participant may borrow the lesser of 50% of their vested account balance or $50,000. An exception exists if 50% of the vested balance is less than $10,000, in which case the participant may still borrow up to $10,000. These limits are in place to ensure participants retain a significant portion of their retirement savings.

The typical maximum repayment period for a 401(k) loan is five years. Payments must be made in substantially level installments, at least quarterly, over this period. An exception to the five-year rule applies to loans used to purchase a primary residence, which may permit a longer repayment term.

If a participant leaves their employment with an outstanding 401(k) loan, the remaining loan balance becomes due within a short period, typically 60 to 90 days. If the loan is not repaid by this accelerated deadline, the outstanding balance is treated as a defaulted loan.

Tax Implications of Unpaid Loans

If a 401(k) loan is not repaid according to its terms, the outstanding balance is reclassified. It is then considered a “deemed distribution” from the 401(k) plan. This means the money is treated as if it were withdrawn from the retirement account, even though the participant did not physically receive it at that moment.

As a deemed distribution, the outstanding loan balance becomes subject to ordinary income tax. This tax is calculated based on the participant’s regular income tax rate for that year. The Internal Revenue Service views this as taxable income because the funds were accessed but not returned to the tax-advantaged retirement account.

Beyond ordinary income tax, an additional 10% early withdrawal penalty may apply if the participant is under age 59½ at the time of the deemed distribution. This penalty is a federal excise tax designed to discourage early access to retirement funds. Certain exceptions to this penalty exist, but generally, an unpaid loan for someone under 59½ incurs both income tax and this additional penalty.