In a NutshellTaking a loan from your 401(k) can be a low-cost way to borrow money — unless you don’t pay the loan back as agreed. Defaulting on your 401(k) loan can have serious tax implications, so before you borrow make sure you have a plan for repaying your loan.
If you need cash, borrowing from your 401(k) can be a low-interest way to quickly get your hands on some money.
Provided your 401(k) plan permits loans, borrowing from your 401(k) may help you pay bills, fund a big purchase or make a down payment on a home.
But you’ll need to pay interest if you want to tap your retirement account. There are also rules you need to follow so that you aren’t taxed on the amount you borrow. And there are possible drawbacks — like missing out on potential investment growth — to consider before deciding to take out a 401(k) loan.
- How does a 401(k) loan work?
- Is there a limit on 401(k) loans?
- How long do you have to repay a 401(k) loan?
- Why do people get 401(k) loans?
- What happens if you leave your job?
- Does a 401(k) loan hurt you?
- What are some alternatives to a 401(k) loan?
1. How does a 401(k) loan work?
If your employer provides a 401(k) retirement savings plan, it may choose to allow participants to borrow against their accounts — though not every plan will let you do so. Borrowing from your own 401(k) doesn’t require a credit check, so it shouldn’t affect your credit.
As long as you have a vested account balance in your 401(k), and if your plan permits loans, you can likely be allowed to borrow against it. Just like with any other loan, you’ll need to repay a loan from your 401(k) with interest within a set time frame. A key difference with this type of loan, though, is that you’re borrowing money from yourself — so you’re paying yourself back, with interest.
2. Is there a limit on 401(k) loans?
Plans can set their own limits for how much participants can borrow, but the IRS establishes a maximum allowable amount. If your plan permits loans, you can typically borrow $10,000 or 50% of your vested account balance, whichever is greater, but not more than $50,000.
For example, if you have $150,000 vested in your 401(k) account, then you wouldn’t be able to borrow the full 50%, or $75,000, of your vested balance. The most you could borrow in that scenario would be $50,000.
On the other hand, if 50% of your vested account balance amounts to less than $10,000, your plan may include an exception and allow you borrow up to $10,000.
You may be able to take more than one loan from your 401(k), but the total amount of your loan balance can’t exceed these limits.
3. How long do you have to repay a 401(k) loan?
Generally, you have up to five years to repay a 401(k) loan, although the term may be up to 25 years if you’re using the money to buy your principal residence. IRS guidance says that loans should be repaid in “substantially equal payments that include principal and interest and that are paid at least quarterly.” Your plan may also allow you to repay your loan through payroll deductions.
The interest rate you’ll pay on the loan is typically determined by the plan administrator based on the current prime rate, but it — and the repayment schedule — should be similar to what you might expect to receive from a bank loan. Also, the interest isn’t paid to a lender — since you’re borrowing your own money, the interest you pay is added to your own 401(k) account.
4. Why do people get 401(k) loans?
As long as a plan allows it, participants generally can borrow from their 401(k) for any reason that they deem necessary. Some plans may only allow loans for specific reasons, so be sure to check your plan’s rules before trying to borrow.
Since you’re borrowing your own money, and no credit check is involved, it may be easier to get approved for a 401(k) loan as long as you meet the plan’s requirements for borrowing. In some cases, a requirement may be getting approval from your spouse (if you’re married), because your spouse may be entitled to half of your retirement assets if you divorce.
Here are some potential uses for a 401(k) loan.
- Paying household bills and expenses
- Funding a down payment on a house
- Paying off high-interest debt
- Covering medical expenses
- Paying back taxes, or money owed to the IRS
- Funding necessary home repairs
- Paying education expenses
But that doesn’t mean 401(k) loans are always a good idea. In fact, there are some major risks that come with borrowing from your retirement savings. Here are two.
5. What happens if you leave your job?
When you take out a loan from a 401(k), you may have no intention of leaving your current employer. But if you receive a better job offer, or are laid off or otherwise leave, you could be required to pay the loan back in full or face some serious tax consequences.
Employees who leave their jobs with an outstanding 401(k) loan have until the tax-return-filing due date for that tax year, including any extensions, to repay the outstanding balance of the loan, or to roll it over into another eligible retirement account. If you can’t repay it, the amount of money you still owe will be considered a “deemed distribution” and could be taxed as it would be if you were to default on the loan.
That means if you left your job in January 2021, you would have until April 18, 2022 (assuming no extensions) — when your 2021 federal tax return is due — to roll over or repay the loan amount. Prior to the Tax Cuts and Jobs Act of 2017, the deadline was 60 days.Learn more: Tax reform gives some 401(k) borrowers more time to repay
If you can’t repay the loan, your employer will treat the remaining unpaid balance as a distribution and issue Form 1099-R to the IRS. That amount is typically considered taxable income and may be subject to a 10% penalty on the amount of the distribution for early withdrawal if you’re younger than 59½ or don’t otherwise qualify for an exemption.
6. Does a 401(k) loan hurt you?
A 2020 report from the Transamerica Center for Retirement Studies found that millennials are already taking out loans against their retirement savings at almost double the rate of older generations. Even so, a 2021 study from the same organization shows that other generations aren’t faring much better. So if you’ve been trying to beat the odds and put aside adequate savings for retirement, taking out a 401(k) loan can be a triple whammy.
First, some plans don’t allow participants to make plan contributions while they have an outstanding loan. If it takes five years for you to repay your loan, that could mean five years without adding to your 401(k) account. During that time, you may be failing to grow your nest egg and you’ll miss out on the tax benefits of contributing to a 401(k).
Next, if your employer offers matching contributions, you’ll miss out on those during any years you aren’t contributing to the plan. Loan repayments aren’t considered contributions, so if the employer contribution is dependent upon your participation in the plan, you may be out of luck if you can’t make contributions while you repay the loan.
And finally, your account will miss out on investment returns on the money you’ve borrowed. Although you do earn interest on the loan, in a low-interest-rate environment you could potentially earn a much better rate of return if the money was invested in your 401(k).
7. What are some alternatives to a 401(k) loan?
When cash is tight, borrowing from your 401(k) plan and paying yourself interest may seem like a good idea. But before you borrow, weigh all your options. Here are a few.
- Consider a home equity loan. If you have equity in your home, a home equity loan may allow you to tap your home’s equity to qualify for a loan. This may be a good option when you need the loan funds for home repairs and improvements, as the interest on a home equity loan could be tax deductible.
- Consider a taxable withdrawal. If you need cash because of a financial hardship, consider a hardship withdrawal rather than a loan (what is considered a hardship withdrawal varies by plan). You’ll likely have to pay income taxes on the distribution, but you may qualify for an exception that allows you to avoid a 10% early-withdrawal penalty. There are disadvantages to hardship withdrawals, too, so make sure to do your research first. If your distribution is related to financial hardship from coronavirus, you may also be eligible to have the 10% penalty waived.
- Consider a personal loan. If your credit is good, you may be able to qualify for a personal loan with favorable terms. You can use the funds from a personal loan to pay for virtually anything. And since they’re typically unsecured, you don’t need to risk collateral to secure the loan.
Depending on your financial situation, a 401(k) loan could be a good option for accessing money to pay off high-interest debt or to cover a big expense. But in other cases, this type of loan could end up costing you, so it might not be the right choice. Remember that it’s not the only option, and you should always explore all possibilities before deciding what type of loan to pursue.
If borrowing from your 401(k) is your only option for accessing necessary cash, make sure you understand all the terms. It’s also important to have a plan for how you’ll repay the loan.
Finally, look for opportunities to pay off your 401(k) loan ahead of schedule by making extra payments when you can — for example, if you have a sudden financial windfall or receive a raise. The sooner you can pay off the loan, the faster you can get back to generating returns on your investment and the less you’ll have to worry about defaulting on the loan or facing a big tax bill if you leave your job.
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