What Is a 403(b) Loan and How Does It Work?

A 403(b) plan is a retirement savings vehicle offered primarily to employees of public schools, certain tax-exempt organizations, and religious institutions. This plan allows participants to save for retirement through payroll deductions, often with pre-tax contributions, similar to a 401(k) plan. Funds within a 403(b) grow tax-deferred until withdrawn in retirement. A loan provision within a 403(b) plan allows participants to borrow a portion of their accumulated retirement savings. This provides access to funds without triggering immediate taxes or penalties, provided the loan is repaid according to the agreed-upon terms.

Key Features of 403(b) Loans

Eligibility for a 403(b) loan generally requires the individual to be an active employee participating in a plan that offers a loan feature. Not all 403(b) plans include a loan provision, so it is necessary to confirm this option with the plan administrator. Typically, loans are only available from a 403(b) plan associated with a current employer, as provisions are usually not extended to plans from former employers.

Federal regulations govern the maximum amount that can be borrowed from a 403(b) plan. A participant can borrow up to 50% of their vested account balance, with an absolute maximum of $50,000, whichever is less. An exception exists for smaller balances, where a participant may borrow up to $10,000 if 50% of their vested account balance falls below this threshold.

The interest rate charged on a 403(b) loan is tied to the prime rate, often the prime rate plus an additional 1%. This rate is lower than what might be found with personal loans or credit cards. The interest paid on the borrowed amount is returned to the participant’s own retirement account, rather than going to a financial institution.

Repayment periods for 403(b) loans are regulated, with a standard maximum term of five years. If the loan proceeds are used for a principal residence purchase, the repayment period may extend up to 15 years. Plan documents may impose stricter limits or different terms than these general guidelines.

When funds are borrowed from a 403(b) account, that portion of the savings is no longer invested in the market. The borrowed money does not participate in potential investment gains or losses during the loan’s term. While the interest paid on the loan goes back into the account, the opportunity for market-driven growth on the principal amount is foregone.

Repaying Your 403(b) Loan

Repayment of a 403(b) loan is typically structured through automatic payroll deductions. This method ensures consistent and timely payments, helping participants stay on schedule. Payments are generally required at least quarterly, often in substantially level amounts that include both principal and interest.

If a participant leaves employment with an outstanding 403(b) loan, the plan may require the full outstanding balance to be repaid immediately or within a short deadline. Failing to repay the loan by this accelerated due date can have serious financial repercussions.

If a 403(b) loan defaults, the unpaid balance is treated as a taxable distribution by the IRS. The outstanding loan amount becomes subject to ordinary income tax. If the participant is under age 59½, an additional 10% early withdrawal penalty may apply to the deemed distribution.

Repayment of a 403(b) loan is made with after-tax dollars. However, when the funds are eventually withdrawn from the 403(b) account in retirement, they will be subject to income tax again if they were originally pre-tax contributions. This can result in a form of double taxation on the loan amount, as the principal is taxed once upon repayment and again upon distribution. An outstanding loan might also affect a participant’s ability to make future contributions to their plan, either due to reduced take-home pay from loan repayments or specific plan stipulations.

Applying for a 403(b) Loan

To apply for a 403(b) loan, contact the plan administrator or the human resources department of the employer. These entities can confirm if a loan provision is available within the specific 403(b) plan and outline the necessary steps. Some plans may also direct participants to the 403(b) provider directly for loan inquiries.

Once availability is confirmed, complete specific forms and documentation. This includes a loan application, a promissory note, and an amortization schedule detailing the repayment terms. These documents formalize the borrowing agreement and outline the participant’s obligations.

Before finalizing the loan, review the loan agreement provided by the plan. This agreement details the interest rate, repayment schedule, and consequences of default. Understanding these specifics ensures clarity.

Processing time for a 403(b) loan can vary, but funds are often disbursed relatively quickly after approval, sometimes within a few business days. Loan proceeds are typically deposited directly into the participant’s designated bank account. Some plans may charge a small application or annual servicing fee for the loan.