Can You Take a Loan on Your 401k? How It Works

A 401(k) loan allows access to retirement savings without immediate taxable distribution. It functions as a loan from one’s vested account balance, not an external lender. Terms and availability depend on the specific 401(k) plan, as not all plans offer this option. This mechanism allows participants to repay themselves, with interest, over a set period, minimizing long-term impact on savings.

Determining Your Eligibility

Eligibility for a 401(k) loan requires plan permission, as not all plans offer it. If available, eligibility depends on your vested account balance (the portion of your retirement savings you fully own), with loans limited to a percentage of this balance.

Federal regulations limit the amount that can be borrowed to the lesser of $50,000 or 50% of your vested account balance. An exception allows borrowing up to $10,000 if 50% of the vested balance is less. Plans can set lower maximums or add restrictions.

An existing 401(k) loan can influence eligibility for another. Some plans limit outstanding loans or reduce the maximum for a new loan. Understanding these rules is essential, as they impact your borrowing capacity.

Financial Structure of a 401(k) Loan

A 401(k) loan means borrowing from your own retirement account, making you both borrower and lender. Funds come directly from your vested account balance, not an external lender. Interest paid on the loan is deposited back into your 401(k) account, contributing to its growth.

Interest rates are tied to the prime rate, often prime plus one or two percentage points. For example, if the prime rate is 8.5%, your rate could be 9.5% to 10.5%. Most repayment periods are up to five years, but up to 15 years may be allowed for a primary residence purchase.

Loan repayments are made through automatic payroll deductions, ensuring consistent payments. This streamlines repayment and helps borrowers adhere to the schedule. However, repayments are made with after-tax dollars and will be taxed again upon retirement withdrawal.

A key financial consideration is the impact on investment growth. Borrowed funds are removed from your 401(k) investment portfolio. These funds will not participate in market gains or returns during the repayment period, potentially affecting long-term retirement savings. While interest paid returns to your account, it may not fully offset missed investment earnings.

If you leave employment with an outstanding loan balance, the remaining balance often becomes due sooner. In many plans, this is by the tax-filing deadline of the year you separate from service. If not repaid, the outstanding balance is treated as a deemed distribution, triggering immediate tax consequences.

Applying for Your Loan

To apply for a 401(k) loan, contact your employer’s HR department, benefits administrator, or the plan’s recordkeeper. They confirm if your plan offers loans and provide terms. Many plans allow checking eligibility and options online.

You will need to complete application forms from your plan administrator. These forms formalize your request and provide necessary information for processing. Once submitted, your application is reviewed for compliance with plan rules and federal regulations.

Upon approval, loan funds are disbursed, typically via direct deposit or check. Timeline varies; electronic transfers often take a few business days, checks may take longer. After receiving funds, confirm the automatic payroll deduction schedule for repayments.

What Happens if You Don’t Repay

Failing to repay a 401(k) loan has significant financial repercussions. If payments are missed and not corrected within a grace period, the outstanding balance is treated as a “deemed distribution” from your 401(k). This means the unpaid amount is considered distributed, even if received as a loan.

This deemed distribution is a taxable event, added to your taxable income. If under 59½, it may also incur a 10% early withdrawal penalty, unless an IRS exception applies. The total deemed distribution, including penalties, will be reported to the IRS on Form 1099-R.

While a defaulted loan is treated as a distribution for tax purposes, the loan obligation may remain on the plan’s books per plan rules. The defaulted amount is permanently removed from your active investment balance, hindering retirement savings growth. Defaulting does not prevent future 401(k) contributions, but the deemed distributed portion is no longer available for investment growth.