What Happens If I Borrow Money From My 401k?

When an unexpected financial need arises, some individuals consider a 401(k) loan as a potential resource. This financial tool allows participants to borrow funds directly from their own retirement savings account. Unlike a traditional loan obtained from a bank, a 401(k) loan involves borrowing from oneself, with the repayment and interest returning to the individual’s own account.

Key Features of 401(k) Loans

A 401(k) loan is a temporary use of funds from your retirement savings, unlike a permanent withdrawal. The money borrowed must be repaid, and the interest charged on the loan is directed back into your own retirement account, not to an external lender. This structure can be appealing because you are essentially paying interest to yourself, which helps your retirement balance grow. These loans do not require a credit check and do not impact an individual’s credit score.

Eligibility to take a 401(k) loan depends on the specific rules of an employer’s plan. Most plans do allow loans, with over 90% offering this feature. To be eligible, an individual must be an active employee with a vested account balance in the plan. The vested balance refers to the portion of the account that an employee fully owns, which always includes their own contributions and any employer contributions that have met the plan’s vesting schedule.

Federal regulations establish limits on how much can be borrowed from a 401(k) plan. The maximum loan amount is the lesser of $50,000 or 50% of the participant’s vested account balance. An exception allows borrowing up to $10,000 if 50% of the vested balance is less than that amount. For example, if a vested balance is $80,000, the maximum loan would be $40,000, but if the balance is $120,000, the maximum remains $50,000.

The interest rate for a 401(k) loan is determined by the plan administrator, based on the prime interest rate plus an additional percentage, commonly 1% or 2%. This rate, while varying, is lower than those found on personal loans or credit cards, making it an attractive option.

Application and Repayment Logistics

The process of obtaining a 401(k) loan begins with understanding your specific plan’s provisions. If your plan does permit loans, the next step involves gathering the necessary preparatory information and forms. Individuals need to specify the desired loan amount and repayment term; some plans may also ask for the reason for the loan. Consult with your human resources department or plan administrator to confirm your plan’s specific requirements.

The application form is provided by the plan administrator or recordkeeper, available through an online portal. Some plans may also require spousal consent for the loan, particularly for amounts exceeding $5,000, though this varies based on plan design and state law. Accurately completing all informational fields, reflecting the precise amount and repayment terms, is crucial. Once completed, the application can be submitted.

The submission process for a completed 401(k) loan application can be done online through the plan’s dedicated portal or via mail. After submission, the application undergoes a review, which takes a few business days, but can extend to a month if additional documentation is required, such as for a home purchase loan. Upon approval, the funds are disbursed via check or direct deposit, with the processing period being brief.

Repayment of a 401(k) loan is managed through automatic payroll deductions, simplifying the process for the borrower. These deductions ensure consistent and timely payments, which include both principal and interest. The Internal Revenue Service (IRS) requires that loans be repaid in “substantially equal payments” made at least quarterly.

The standard maximum repayment period for a 401(k) loan is five years. However, if the loan is used for the purchase of a primary residence, the repayment term can be extended up to 10 or 15 years, depending on the plan’s provisions. Borrowers have the flexibility to repay the loan earlier without incurring any prepayment penalties.

If a borrower changes jobs with an outstanding 401(k) loan, a consideration arises. Many plans require the full repayment of the loan balance shortly after employment termination, whether voluntary or involuntary. Historically, this meant a repayment deadline within 60 to 90 days. However, recent changes in tax law have extended this grace period.

Under current regulations, if you leave your job with an outstanding 401(k) loan, you have until the tax-filing due date for that tax year, including any extensions, to repay the outstanding balance or roll it over. For instance, if employment ends in January 2025, the repayment or rollover deadline would be April 15, 2026, assuming no extensions. If the loan is not repaid or rolled over by this extended deadline, the outstanding balance is then treated as a taxable distribution, triggering potential tax consequences.

Tax Consequences of Non-Repayment

Failing to repay a 401(k) loan according to its terms can lead to tax implications. When a loan is not repaid by the specified deadline or if payments are missed and not corrected within a grace period, the outstanding balance is considered a “deemed distribution.” This occurs because the loan no longer meets the IRS requirements for a tax-free loan and is treated as if the funds were distributed from the plan.

A deemed distribution is then treated as ordinary taxable income in the year of the default. This means the outstanding loan amount is added to the individual’s taxable income for that year, potentially increasing their tax liability. For example, if a $50,000 loan goes into default, that $50,000 becomes part of the individual’s taxable income.

In addition to being taxed as ordinary income, a deemed distribution incurs an additional 10% early withdrawal penalty. This penalty applies if the participant is under age 59½ at the time the loan is deemed distributed. There are limited exceptions to this penalty, such as for certain medical expenses or disability, but these are specific and do not apply to defaulted loans.

For tax reporting purposes, the amount of the deemed distribution is reported to the IRS on Form 1099-R. This form indicates that a distribution has occurred, even though the individual did not physically receive new funds at that time. Once a loan is deemed distributed, it cannot be rolled over into another retirement account to avoid tax consequences. While the loan is treated as a distribution for tax purposes, the individual may still be obligated to repay the loan to the plan, as it remains an outstanding debt on the plan’s books.