Can You Borrow Money Against Your 401k?

A common feature of many 401(k) plans allows participants to borrow a portion of their vested account balance. This is a loan taken against your own accumulated savings within the retirement plan, not a withdrawal or a loan from a bank. The money borrowed comes from your own account, under specific rules and conditions set by the plan and federal regulations.

Understanding 401(k) Loans

A 401(k) loan involves borrowing directly from your own vested account balance, rather than from an external lender. Interest paid on the loan goes back into your 401(k) account, returning it to your retirement savings. Not all plans offer loan provisions; eligibility is determined by the specific 401(k) plan document.

Participants consider a 401(k) loan for short-term liquidity needs, as it provides access to funds without impacting personal credit scores since lenders do not conduct credit checks. The process can be relatively straightforward compared to obtaining traditional loans. Repayment occurs through regular deductions from the borrower’s payroll.

Key Terms and Conditions

Federal regulations and plan documents dictate the rules for 401(k) loans. The maximum loan amount is the lesser of 50% of your vested account balance or $50,000. An exception exists for smaller balances: if 50% of the vested account balance is less than $10,000, participants may borrow up to $10,000.

Most 401(k) loans must be repaid within five years. However, if the loan is specifically used for the purchase of a primary residence, the repayment term can extend, sometimes up to 15 or 30 years, depending on the plan. Interest rates for 401(k) loans are determined by taking the prime rate and adding a percentage, often one or two points, ensuring a commercially reasonable rate. This interest is paid directly back into your 401(k) account.

Repayment is structured through regular payroll deductions. Plans may also have rules regarding the number of outstanding loans a participant can have simultaneously. Some plans might also charge administrative fees for processing a loan, which can range from $50 to $100 for origination, and potentially service fees of $20 to $50.

Navigating Repayment and Default

Loan repayments are managed through automatic payroll deductions, ensuring consistent and timely payments. It is important to adhere to this payment schedule, as missing payments can lead to consequences. Some plans may offer a grace period, often until the end of the calendar quarter following the quarter in which a payment was missed, before classifying the loan as defaulted.

If a 401(k) loan is not repaid, the outstanding balance is treated by the IRS as a “deemed distribution.” The unpaid amount becomes subject to income tax at your ordinary income tax rate. If the participant is under age 59½, a 10% early withdrawal penalty, as outlined in Internal Revenue Code Section 72, will apply to the defaulted amount.

If a participant leaves their employer with an outstanding 401(k) loan, many plans require the full balance to be repaid immediately or within a short grace period, often 60 to 90 days following termination. If not repaid within this timeframe, the outstanding balance is treated as a taxable distribution, incurring both income tax and the potential 10% early withdrawal penalty if applicable.

The Application Process

Initiating a 401(k) loan begins with confirming if your plan offers this provision. Consult your plan’s Summary Plan Description (SPD), a detailed document outlining plan features and rules, or contact your plan administrator. The SPD provides information on eligibility, terms, and conditions.

Once eligibility is confirmed, the application process involves submitting a request through an online portal, contacting human resources, or completing forms provided by the plan administrator. The application requires personal identification details, the desired loan amount, and sometimes the purpose of the loan, especially if for a primary home purchase to qualify for an extended repayment term.

Upon approval, funds are disbursed, often via direct deposit or a check, within a few business days to a week. Before receiving the funds, you must sign a loan agreement. This document outlines the terms and conditions of the loan, including the repayment schedule and consequences of default.