What Percentage of a 401k Can You Borrow?
Borrowing from your 401(k) is subject to specific IRS rules based on your vested balance and loan history. Understand how this framework impacts your loan amount.
Many employer-sponsored retirement plans allow participants to borrow from their 401(k) savings. This option provides access to funds without a traditional credit check, as the loan is secured by the assets within the account. The process is governed by federal regulations from the Internal Revenue Service (IRS), but individual 401(k) plans may also impose their own, more restrictive, rules.
Calculating Your Maximum Loan Amount
The amount an individual can borrow from their 401(k) is determined by an IRS formula. A participant can borrow up to 50% of their vested account balance, not to exceed $50,000. Federal rules include a special provision for smaller balances: if the plan permits, a participant may borrow up to $10,000, even if it is more than 50% of their vested funds, as long as their vested balance is less than $20,000. An employer’s plan may set lower borrowing limits or choose not to offer the special $10,000 provision.
The concept of a “vested balance” is central to this calculation. An employee’s vested balance is the portion of their 401(k) that they own outright, which always includes their own contributions and any earnings. It also includes employer contributions that have met the plan’s vesting schedule. Any unvested employer contributions are not included when calculating the loan limit, so the available loan amount may be based on a figure smaller than the total account value.
The $50,000 cap is reduced by the highest outstanding balance of any other 401(k) loans the participant has had within the preceding 12 months. This “look-back” rule prevents individuals from circumventing the limit by repaying one loan and immediately taking out another. For example, if a participant with a $150,000 vested balance had a previous loan with a highest outstanding balance of $20,000 in the last year, the new maximum loan they could take is reduced to $30,000.
This calculation can be nuanced, so plan administrators provide tools to help participants determine their exact borrowing capacity. These modeling tools, often available on the plan’s online portal, show a user’s specific maximum loan amount based on their current vested balance and any recent loan history. Before proceeding, it is advisable to use these resources or contact the plan administrator directly to confirm the precise amount available.
The Loan Application and Required Information
Before applying for a 401(k) loan, you must first confirm that your employer’s plan offers this feature. You can verify eligibility by reviewing the Summary Plan Description (SPD), which outlines all plan rules and is usually available on the plan administrator’s website.
The application process requires gathering the necessary information. You will need to decide on the exact loan amount and select a repayment period that fits within plan and IRS limits. Some plans may also require you to state the reason for the loan, such as for a home purchase or medical expenses.
The application itself is a straightforward form found on the 401(k) provider’s website. It will require personal identifying information, the requested loan amount, and the chosen repayment term. The approval process is generally quick since it does not involve a credit check, with funds often disbursed within a few business days.
Repayment Terms and Structure
Federal regulations mandate a maximum repayment term of five years for general-purpose loans. An exception to this rule exists for loans used to purchase a primary residence. In these specific cases, the plan may permit a much longer repayment period, such as 15 or 30 years.
The most common method for repaying a 401(k) loan is through automatic payroll deductions. The plan administrator works with the employer to set up these deductions, ensuring a fixed amount is taken from each paycheck. Payments must be made at least quarterly and consist of both principal and interest.
The interest paid on the loan is not directed to a third-party lender. Instead, the borrower pays the interest back into their own 401(k) account. The interest rate is set by the plan administrator and must be “commercially reasonable,” often benchmarked to the prime rate plus a small margin. This means that while repaying the loan, the participant is also contributing interest earnings back to their retirement savings.
Consequences of Loan Default
Failure to repay a 401(k) loan according to its terms results in a default, which carries significant financial consequences. A default is triggered if payments are not made on schedule and the issue is not corrected within a grace period, which usually lasts until the end of the calendar quarter following the missed payment. A default also occurs if an employee leaves their job and does not repay the outstanding loan balance by the plan’s deadline.
When a loan defaults, the IRS treats the entire outstanding balance as a taxable distribution from the 401(k) plan. The plan administrator will report this “deemed distribution” to the individual and the IRS on Form 1099-R. The borrower must then include the full amount of the defaulted loan in their gross income for the tax year in which the default occurred.
In addition to income tax, a defaulted loan can trigger a penalty. If the individual is under the age of 59.5 at the time of the default, the deemed distribution is subject to a 10% early withdrawal penalty. For example, a $20,000 defaulted loan for someone in a 22% federal tax bracket who is under 59.5 could result in $4,400 in income tax and an additional $2,000 penalty, for a total immediate cost of $6,400, not including state income taxes.