What Is the Difference Between a 401k Loan and Withdrawal?

A 401(k) plan is a foundational component of many retirement savings strategies. However, individuals sometimes need to access these funds before retirement. When faced with an immediate financial need, two primary avenues are a 401(k) loan or a withdrawal. Understanding the distinct characteristics and implications of each is crucial for an informed decision.

Understanding 401(k) Loans

A 401(k) loan allows participants to borrow money directly from their own retirement account. Interest paid on the loan is returned to their account.

Limits are set on how much can be borrowed, generally the lesser of 50% of the vested account balance or $50,000. However, if 50% of the vested balance is less than $10,000, some plans may allow borrowing up to $10,000.

Repayment of a 401(k) loan typically occurs through regular, fixed payments, often deducted directly from the participant’s payroll. Most general-purpose 401(k) loans must be repaid within five years, with payments made at least quarterly. An exception to this five-year rule applies if the loan is used to purchase a primary residence, which may allow for an extended repayment period, potentially up to 15 years.

A significant aspect of 401(k) loans is the tax implication if the loan is not repaid according to the established schedule. If loan repayments are missed or the loan is not fully repaid within the stipulated time, the outstanding balance is treated as a “deemed distribution” by the IRS. This deemed distribution becomes immediately taxable as ordinary income in the year of the default. Furthermore, if the participant is under age 59½ at the time of the default, the deemed distribution may also be subject to an additional 10% early withdrawal penalty.

Not all 401(k) plans offer a loan feature; this is at the employer’s discretion. Even when available, the borrowed funds are temporarily removed from the investment portfolio, meaning they do not participate in any market gains or losses during the loan period. This can impact the overall growth potential of the retirement savings.

Understanding 401(k) Withdrawals

A 401(k) withdrawal, or distribution, permanently removes funds from the retirement account with no repayment obligation. Generally, withdrawals are permitted without penalty once a participant reaches age 59½. Other circumstances that may allow for penalty-free withdrawals include separation from service at age 55 or later, qualifying disability, or death.

A hardship withdrawal allows access to funds for an “immediate and heavy financial need,” as defined by the IRS. Reasons for hardship withdrawals include unreimbursed medical expenses, costs to purchase a principal residence, payments to prevent eviction or foreclosure, and certain expenses for the repair of damage to a principal residence. While a hardship withdrawal may address an urgent need, it is typically subject to income tax and, unless a specific exception applies, the 10% early withdrawal penalty if the participant is under age 59½.

In-service withdrawals, if permitted by the plan, allow participants to take money out while still employed, often after reaching a certain age or years of service. Rollovers represent a type of withdrawal where funds are moved from a 401(k) to another qualified retirement account, such as an Individual Retirement Account (IRA). A direct rollover avoids immediate taxation and penalties, as the funds are transferred directly between financial institutions.

The distributed amount from a 401(k) withdrawal is generally treated as ordinary income in the year received. For withdrawals taken before age 59½, an additional 10% early withdrawal penalty typically applies, unless an exception is met. Exceptions to this penalty include distributions for qualified medical expenses exceeding 7.5% of adjusted gross income, substantially equal periodic payments, qualified reservist distributions, and distributions due to a permanent disability. A withdrawal permanently reduces the account balance and eliminates the potential for those funds to grow and compound over time.

Key Distinctions Between Loans and Withdrawals

The fundamental difference between a 401(k) loan and a withdrawal is the repayment obligation. A loan requires repayment to the account, restoring funds to retirement savings. A withdrawal permanently removes funds with no repayment.

Regarding tax implications, loans are generally tax-free and penalty-free if repaid. If a loan defaults, the outstanding balance becomes a taxable distribution and may incur a 10% early withdrawal penalty. Withdrawals are typically taxable as ordinary income, and most early withdrawals are also subject to a 10% penalty unless an exception applies.

The impact on retirement savings also differs significantly. Loaned funds are temporarily removed from investment but return upon repayment, allowing for resumed growth. Withdrawn funds are permanently removed, eliminating future investment growth for that amount.

Access to funds also varies. Loans are generally available at any time, subject to the plan’s rules and maximum borrowing limits, and do not typically require a specific qualifying event. Withdrawals, on the other hand, usually have stricter eligibility requirements, such as reaching a certain age, separating from service, or demonstrating an immediate and heavy financial need. Employer discretion plays a role in both, as plans may or may not offer loans or certain types of withdrawals.