What Happens If You Borrow From Your 401k?

Borrowing from a 401(k) plan offers access to funds without involving traditional lenders or credit checks. Many employer-sponsored 401(k) plans allow participants to borrow against their vested account balance. Understanding the specific rules and potential outcomes associated with a 401(k) loan is important.

Understanding 401(k) Loan Rules

Accessing funds from a 401(k) through a loan is available to active employees whose employer’s plan permits such borrowing. Not all 401(k) plans offer a loan option, so participants should confirm their plan’s specific provisions. The amount that can be borrowed is subject to federal limits, set at the lesser of 50% of the participant’s vested account balance or $50,000. An exception allows borrowing up to $10,000 if 50% of the vested balance is less than $10,000.

Vested balance refers to the portion of the retirement account that an employee fully owns, including all personal contributions and any employer contributions that have met the plan’s vesting schedule. While employee contributions are always 100% vested immediately, employer contributions may require a certain period of service before becoming fully vested. The interest rate on a 401(k) loan is determined by the plan administrator, often based on the prime rate plus a small percentage, such as one percent. The interest paid on the loan goes back into the participant’s own 401(k) account, effectively meaning you pay interest to yourself.

The standard repayment period for a 401(k) loan is five years. However, if the loan proceeds are used to purchase a primary residence, the repayment period may be extended up to 10 or 15 years. The application process involves contacting the plan administrator, HR department, or accessing an online portal, where information such as the desired loan amount and proposed repayment schedule will be required.

The Repayment Process

Once a 401(k) loan is taken, the repayment process involves regular, scheduled payments. These payments are most commonly made through automatic payroll deductions, which helps ensure consistency and simplifies the repayment for the borrower. Payments are required at least quarterly, with many plans allowing for more frequent payments.

Borrowers can repay the loan faster than the scheduled term without incurring any prepayment penalties. This flexibility allows individuals to clear the debt sooner if their financial situation improves. Additional payments can also be made manually through various methods, including direct bank transfers or mailing a check.

A job change impacts 401(k) loans. If a borrower leaves their employment, the outstanding loan balance becomes due sooner than the original repayment schedule. Many plans require full repayment within a short timeframe, often 60 to 90 days, or by the due date of the borrower’s next federal tax return including extensions. Failure to repay the loan within this accelerated period can lead to financial and tax consequences, as the unpaid balance may be treated as a defaulted distribution.

Financial and Tax Outcomes

Borrowing from a 401(k) can have financial and tax implications, particularly if the loan is not repaid as required. One primary financial outcome is opportunity cost: the money borrowed is no longer invested within the 401(k) account and misses out on potential investment growth and compounding returns. While interest paid on the loan returns to the account, the principal does not participate in market gains during the loan period.

Unlike interest on many other types of loans, the interest paid on a 401(k) loan is not tax-deductible. This holds true regardless of how the loan proceeds are used, even if for a home purchase. Repayments are made with after-tax dollars, meaning the money has already been taxed once. The principal and interest paid back into the plan will be taxed again upon withdrawal in retirement, a concept sometimes referred to as “double taxation” of the interest portion.

A significant consequence arises if the loan is not repaid according to its terms, leading to a “deemed distribution.” This occurs when a loan falls out of compliance. When a loan is deemed distributed, the outstanding balance is treated as a taxable withdrawal from the 401(k) plan, subject to ordinary income tax in the year the default occurs.

If the borrower is under age 59½ at the time of the deemed distribution, an additional 10% early withdrawal penalty will apply to the outstanding loan balance. A deemed distribution is a taxable event, but it does not mean the loan is forgiven; the participant may still be obligated to repay the loan to the plan. Defaulting on a 401(k) loan can also negatively impact a participant’s ability to take future loans from the same plan.