Can You Take Out a Loan Against Your 401(k)?

A 401(k) plan serves as a foundational component of retirement savings for many individuals, allowing for tax-advantaged contributions throughout a working career. These employer-sponsored plans enable participants to save and invest for their future, often with employer matching contributions. While the primary purpose of a 401(k) is long-term wealth accumulation for retirement, certain circumstances may lead individuals to consider accessing these funds earlier. One such option, permitted by many plans, involves taking a loan directly from the vested balance within the 401(k) account. This approach differs significantly from a withdrawal, as the borrowed funds are expected to be repaid to the account, typically with interest.

Eligibility and Borrowing Limits

Not all 401(k) plans offer a loan feature, as it is an optional provision determined by the plan administrator. Employers are not mandated to provide loans, and those that do may impose their own specific conditions and restrictions. Even when a loan option is available, certain eligibility criteria must be met by the participant. Typically, only active employees of the company sponsoring the 401(k) plan are eligible to take out a loan.

The Internal Revenue Service (IRS) sets specific limits on the maximum amount that can be borrowed from a 401(k) plan to ensure that such transactions are treated as loans rather than taxable distributions. Generally, a participant can borrow the lesser of $50,000 or 50% of their vested account balance. For instance, if an individual has a vested balance of $80,000, the maximum loan amount would be $40,000. Similarly, if the vested balance is $120,000, the maximum loan would still be $50,000.

An exception to this 50% rule allows borrowing up to $10,000 if 50% of the vested account balance is less than that amount. The “vested account balance” refers to the portion of the account that the employee fully owns. This includes their own contributions and any employer contributions that have met the plan’s vesting schedule. Employer contributions not yet vested are not eligible for a loan.

The calculation of the maximum loan amount also considers any outstanding loan balances from the past 12 months. If a participant has had previous 401(k) loans within the last year, the $50,000 limit is reduced by the highest outstanding loan balance during that 12-month period. For example, if a participant’s vested balance is $100,000 and they had an outstanding loan balance of $10,000, the maximum new loan amount would be $40,000. This rule prevents individuals from continuously re-borrowing the full amount.

Individual plan documents can impose stricter limits than those set by the IRS. Some plans may have lower maximum borrowing amounts or limit the number of outstanding loans a participant can have at one time. Participants should review their specific plan’s terms and conditions to understand their eligibility and borrowing capacity.

Loan Repayment and Interest

Repaying a 401(k) loan requires adherence to specific terms and schedules mandated by federal regulations and the individual plan document. Generally, a 401(k) loan must be repaid within five years for most general-purpose loans. An exception exists for loans used to purchase a primary residence, which may allow for a longer repayment term, potentially up to 15 years or more.

Loan repayments are typically made through mandatory regular payroll deductions. These deductions are usually taken from after-tax dollars. The repayment schedule must involve substantially equal payments of principal and interest, made at least quarterly over the life of the loan. This structured repayment helps ensure the loan is amortized properly and paid back within the required timeframe.

The interest rate charged on a 401(k) loan is generally determined by the plan, often tied to the prime rate plus an additional percentage. For example, if the prime rate is 8.25%, the loan rate might be between 9.25% and 10.25%. Unlike traditional loans, a participant’s credit score does not affect the interest rate, as it is based on borrowing from one’s own retirement savings.

A distinctive aspect of 401(k) loans is that the interest paid goes back into the participant’s own 401(k) account, rather than to an external lender. While this can be seen as “paying yourself back,” the borrowed funds are removed from the market and do not participate in potential investment gains during the loan period. Adhering to the repayment schedule is important to avoid significant tax consequences and penalties.

Tax Consequences of Non-Repayment

Failing to repay a 401(k) loan according to its terms can lead to significant tax implications. An unpaid loan balance, or any portion of it that is not repaid by the specified deadline, is generally considered a “deemed distribution” from the 401(k) plan. The loan is deemed distributed in the year the default occurs.

A primary consequence of a deemed distribution is that the outstanding balance becomes taxable income in the year it is deemed distributed. This amount is added to the individual’s gross income and is subject to ordinary income tax rates. For instance, if a participant defaults on a $20,000 loan, that amount will be added to their taxable income, potentially pushing them into a higher tax bracket.

In addition to being treated as taxable income, if the participant is under age 59½ at the time of the deemed distribution, the amount is typically subject to an additional 10% early withdrawal penalty. For example, a $20,000 deemed distribution for someone under 59½ would incur a $2,000 penalty on top of the income tax.

The plan administrator reports the deemed distribution to the IRS and the participant, typically on Form 1099-R. A deemed distribution does not mean the loan obligation is forgiven; the participant may still be required to repay the loan to the plan, even after it has been taxed. Payments made after a deemed distribution are considered after-tax contributions to the plan.