Does Taking Out a Loan on Your 401k Affect Credit?

A 401(k) loan involves borrowing money from one’s own retirement savings account. Many individuals wonder if taking out such a loan can impact their credit score. This article aims to clarify the relationship between 401(k) loans and credit, explaining how these loans function and what happens if they are not repaid.

Understanding 401(k) Loans

A 401(k) loan is a financial arrangement where an individual borrows funds directly from their vested balance within their employer-sponsored retirement plan. Unlike traditional loans obtained from banks or other financial institutions, the money for a 401(k) loan comes from the borrower’s own savings, not from an external lender. This distinction means that the interest paid on the loan is returned to the individual’s own 401(k) account, rather than going to a third party.

The Internal Revenue Service (IRS) sets rules for these loans. Generally, the maximum amount an individual can borrow is the lesser of $50,000 or 50% of their vested account balance. However, an exception allows for borrowing up to $10,000, even if 50% of the vested balance is less than that amount. Repayment of a 401(k) loan typically occurs through automatic payroll deductions, with payments usually made at least quarterly and structured to include both principal and interest.

Most 401(k) loans must be repaid within five years. A longer repayment period, often up to 15 years, may be permitted if the loan is specifically used for the purchase of a primary residence.

How Credit Scores are Determined

Credit scores, such as FICO and VantageScore, are numerical representations of an individual’s creditworthiness. These scores are calculated based on information contained in credit reports, which are compiled by major credit bureaus like Experian, Equifax, and TransUnion. Lenders report a consumer’s borrowing and repayment activities to these bureaus, forming the basis of the credit report.

Several factors contribute to the calculation of a credit score. Payment history is a primary factor, reflecting whether bills have been paid on time. The amounts owed, also known as credit utilization, is another significant component, indicating the proportion of available credit that is currently being used.

The length of credit history, which considers how long accounts have been established, also influences the score. Additionally, the mix of different credit types, such as credit cards, installment loans, and mortgages, can affect a score. New credit inquiries are a minor factor.

The Direct Relationship to Credit

401(k) loans are generally not reported to the three major credit bureaus: Experian, Equifax, or TransUnion. This is because the loan is an arrangement between the individual and their own retirement plan, not with a traditional third-party lender. A significant characteristic of these loans is that no credit check is required to obtain them, as the loan is secured by the borrower’s own retirement savings.

Consequently, the act of borrowing from a 401(k) account does not appear on one’s credit report. Making timely payments on a 401(k) loan will not improve a credit score, nor will missing payments directly harm it. Therefore, a 401(k) loan has no direct impact on an individual’s credit score.

Consequences of Not Repaying a 401(k) Loan

While a 401(k) loan does not affect one’s credit score, failing to repay it can lead to significant financial consequences. If an individual defaults on a 401(k) loan, or if they leave their employer before the loan is fully repaid and do not meet the repayment terms, the outstanding balance is typically treated as a “deemed distribution” by the IRS.

This deemed distribution means the unpaid loan balance is considered taxable income for that year. The amount will be added to the individual’s gross income, increasing their tax liability. Furthermore, if the individual is under the age of 59½ at the time of the deemed distribution, the amount may also be subject to an additional 10% early withdrawal penalty.

These tax implications and penalties can substantially reduce an individual’s retirement savings and create an unexpected tax burden. It is important to understand that even after a loan is deemed distributed and taxed, the individual may still be obligated to repay the loan to the plan, depending on the plan’s specific rules.