Can You Withdraw From 401(k) If You Have a Loan?

A 401(k) plan is a tax-advantaged vehicle designed to help individuals save for retirement. Participants can contribute a portion of their earnings, often with employer contributions. Some plans allow participants to borrow against their vested account balance through a 401(k) loan. A 401(k) withdrawal involves directly taking money out of the account. Understanding how these two aspects interact, especially with an outstanding loan, is important for managing retirement savings.

How an Outstanding Loan Interacts with a 401(k) Withdrawal

When a participant takes a withdrawal from their 401(k) while an outstanding loan exists, the loan typically becomes immediately due and payable. The individual is generally required to repay the full outstanding loan balance by a specific deadline. If the loan is not repaid by this deadline, the outstanding balance is treated as a “deemed distribution” from the 401(k) plan.

A deemed distribution signifies that for tax purposes, the unpaid loan amount is considered distributed from the retirement account, even though no cash physically changes hands. The plan administrator will “offset” the outstanding loan balance against the participant’s vested account balance. This offset reduces the amount of cash the participant actually receives from their requested withdrawal. For example, if a participant requests a $20,000 withdrawal but has a $5,000 outstanding loan, the plan may only disburse $15,000 in cash, while the $5,000 loan balance is simultaneously treated as a deemed distribution.

Tax Implications of Withdrawing with an Outstanding Loan

Both the actual cash withdrawal and any deemed distribution resulting from an unpaid loan are generally subject to ordinary income tax. This means the amount is added to the individual’s gross income for the year and taxed at their marginal income tax rate. The Internal Revenue Service (IRS) requires these distributions to be reported on Form 1099-R.

For individuals under age 59½, an additional 10% early withdrawal penalty typically applies to both the actual cash withdrawal and the deemed distribution. This penalty is imposed to discourage early access to retirement funds. Exceptions to this 10% penalty exist, such as distributions due to permanent disability, certain unreimbursed medical expenses, or separation from service at age 55 or older.

The Form 1099-R issued by the plan administrator will show the total amount considered distributed, including both the cash received and the deemed distribution from the loan offset. This form is essential for accurately reporting the income and any applicable penalties on the individual’s federal income tax return.

Specific Situations Affecting 401(k) Loans and Withdrawals

Job Termination/Change

Upon leaving employment, an outstanding 401(k) loan typically becomes due and payable immediately. Many plans provide a grace period for the participant to repay the loan in full. If the loan is not repaid within this period, the outstanding balance is treated as a deemed distribution. This deemed distribution is then subject to ordinary income tax and, if the individual is under age 59½, the 10% early withdrawal penalty also applies. In some cases, a deemed distribution might qualify as a “qualified plan loan offset” (QPLO), allowing the individual to roll over the amount to another retirement account by their tax return due date to avoid immediate taxation.

Hardship Withdrawals

A hardship withdrawal allows participants to access 401(k) funds for immediate and heavy financial needs. While a hardship withdrawal can provide necessary funds, it does not alter the repayment terms of an existing 401(k) loan. Any outstanding loan remains subject to its original repayment schedule and conditions. If a participant takes a hardship withdrawal and subsequently fails to repay an outstanding loan, the unpaid loan balance will be treated as a taxable distribution. If the participant is under age 59½, it will typically incur the 10% early withdrawal penalty.

In-Service Withdrawals (Age 59½)

Some 401(k) plans permit participants to take “in-service” withdrawals once they reach age 59½, even while still employed. For individuals over this age, the 10% early withdrawal penalty generally does not apply to the cash withdrawal. However, an outstanding loan must still be repaid according to its terms, or it will be treated as a deemed distribution. Although the 10% early withdrawal penalty may be avoided if the participant is over 59½, the deemed distribution amount will still be subject to ordinary income tax.