How Does a 401(k) Loan Work?

A 401(k) is an integral part of many people’s retirement strategies. But did you know you may be able to take out a loan against it?

money in wallet

There are plenty of pros and cons associated with this plan. However, it can be beneficial to avoid the loan application process, credit check, and heavy interest associated with many lenders.

It’s a big decision to make, so we’ll walk you through the entire process to help you understand exactly what to expect with a 401(k) loan.

Ready to get started?

What is a 401(k) loan?

If your employer offers a 401(k) to employees as part of your retirement savings strategy, chances are you could be eligible to take out a loan from your contributions.

After all, among both mid and large-sized companies, a full 94% allow 401(k) loans on the money you have contributed. In addition, 73% of these employers also allow employees to borrow money against the employer’s contributions.

So, you can borrow money from your own retirement savings rather than waiting for them to accumulate or paying a 10% penalty tax as you would with a traditional IRA.

Eligibility Criteria for a 401(k) Loan

There are a few restrictions surrounding a 401(k) loan. While we mentioned that many larger companies typically allow you to borrow for your account, not all do. You can find out about your workplace policy by referencing your employee handbook or contacting the human resources department.

You also must still be working at the company where you had your 401(k) to take out a loan. So if you left willingly or were fired, unfortunately, you aren’t able to take advantage of this opportunity.

There are also some limits on how much you can borrow from your account. IRS regulations state that you can only borrow the smaller of the following two options:

  • $50,000 or
  • Half the amount of your vested account balance

Your interest rate is also determined by when you borrow. That’s because it’s typically set at the prime rate plus an extra 1% to 2%. So if the prime rate is at 4.25% and your employer’s 401(k) plan adds 2%, you’re looking at a 6.25% interest rate. The interest does, however, go directly back into your retirement account.

Benefits of Borrowing from Your 401(k)

Like any financial product, the 401(k) loan comes with both pros and cons. Some experts scream that you should never touch your retirement savings, while others have noted countless success stories.

It’s essential to weigh the positives and negatives concerning your situation thoroughly. Then, you can make a fully informed decision on whether a 401(k) loan is right for you specifically.

Being your own lender comes with a few perks.

Easy Approval

First, you don’t have to fill out an application. There’s no underwriting process since the funds are already in your name. You also don’t have to worry about any type of minimum credit score.

So if you need an infusion of cash for some reason but have gone through a rough financial patch, you can sidestep a bad credit loan and the accompanying bad credit.

Repayment Terms

Repaying a 401(k) loan involves direct deductions from your paycheck, which reduces your take-home pay. For example, a monthly repayment of $200 will decrease a $3,000 take-home pay to $2,800. It’s important to budget with this reduced income in mind.

If repayments are missed, the loan may default. The remaining balance then becomes a taxable distribution, potentially incurring a 10% early withdrawal penalty if you’re under 59 ½. This could significantly raise the loan’s cost.

Remember, while repaying the loan, the borrowed funds aren’t earning investment returns, impacting your retirement savings growth. Consider these factors carefully to understand how a 401(k) loan fits into your financial planning.

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Use of Loan Funds

401(k) loans offer flexibility in how you can use the borrowed funds, whether for home repairs, education, or debt consolidation. However, you must use this money responsibly. Since these funds are part of your retirement savings, using them for non-essential expenses can jeopardize your financial future.

Consider the long-term implications before diverting retirement savings for current expenses. It’s wise to reserve 401(k) loans for situations that contribute to your financial stability or urgent needs, rather than discretionary spending. Misusing these funds can lead to a shortfall in your retirement account, affecting your financial security in your later years.

Lower Interest Rate

Borrowing from your 401(k) typically offers a lower interest rate compared to credit cards or personal loans. This can be a cost-effective borrowing option, especially if you’re facing high-interest debt. However, consider the long-term impact on your retirement savings when opting for a 401(k) loan.

Drawbacks of Borrowing from Your 401(k)

It’s important to consider both the short- and long-term impacts of taking money out of your 401(k).

Double Taxed

Double taxation on a 401(k) loan can be confusing. Essentially, when you repay the loan, you do so with after-tax dollars. This means the money you use for repayment has already been taxed as part of your income taxes. Later, when you withdraw from your 401(k) in retirement, you are taxed again on these funds.

For example, if you pay $1000 back into your 401(k) as loan repayment, this $1000 has already been taxed as part of your salary. When you retire and withdraw this money, it’s taxed again as income.

Further Contributions

You also may not be allowed to continue making retirement contributions during the repayment period. It depends on your employer’s plan. During this process, your retirement nest egg could suffer.

First, you’d lose any gains made on the funds you took out. Then, you’d be taking a hiatus for at least a few years. That can really add up when you think about compounding gains.

Leaving Your Job Could Accelerate Loan Repayment

If you leave your job, voluntarily or not, while a 401(k) loan is outstanding, the remaining balance often becomes due within 60 days. This can create a significant financial burden, especially if the loan amount is large.

Plan carefully and consider the stability of your current employment situation before taking a 401(k) loan, as unforeseen job changes could lead to challenging repayment demands.

Financial Penalties from Defaulting on a 401(k) Loan

Failing to repay a 401(k) loan can lead to significant financial consequences. If you default, the unpaid balance is treated as a taxable distribution. For those under 59 ½, this also incurs a 10% early withdrawal penalty.

These penalties, combined with the owed taxes, can substantially increase the cost of the loan, impacting your current financial health and diminishing your retirement savings.

Repayment Process: How to Manage Your 401(k) Loan

If you decide to take out a 401(k) loan, make sure you understand how the loan repayment process works. Your loan payments are taken directly out of your paycheck, but there is a certain degree of risk involved. If, for some reason, you can’t (or simply don’t) make a payment for 90 days, you’ll incur significant penalties.

It’s almost considered to be a short-term default because you’ll pay taxes on it and the 10% early withdrawal penalty on the amount owed.

When you take out a 401(k) loan, you don’t have to pay any type of application fee or origination fee, so it seems like a low-cost option. But again, you have to consider the money you’re losing by not having as much invested in your account.

A great way to analyze the numbers is to use a retirement calculator. You can figure out how much you’d have to sacrifice to get your loan funds right away, and then decide whether it’s worthwhile.

Is a 401(k) loan right for you?

This is a personal decision, and there are many factors to consider regarding whether a 401(k) loan is a good idea. First, think about how far away you are from retirement. If you’re expecting to start making withdrawals in the near future, you may want to reconsider dipping into that money ahead of schedule.

If you’re further away from retirement, you have more time to make up for any financial losses you’d incur while the loan is out. Just make a plan to ensure you’re able to catch up over time.

Of course, your intended use for your 401(k) loan funds also affects whether it’s a good choice. Short-term uses are a little less worrisome. For example, if you’re using it for a down payment on a house and can quickly repay the loan, it can be a good way to avoid those penalties.

But if you’re using the 401(k) loan as a band-aid during an ongoing financial downturn, you may want to think again. Is it really solving the problem or just providing temporary relief?

Furthermore, think twice about using your 401(k) loan to pay off debts. If you’re still in financial trouble, you can lose your existing assets.

But retirement savings are typically protected from any kind of insolvency, but not if they’ve been taken out as a loan. If there’s a chance you might lose the money permanently, try to find another solution.

Alternatives to Using Your 401(k) for a Loan

A 401(k) loan isn’t the only alternative to a traditional personal loan. Here are a few other options to consider.

Emergency Savings

Ideally, you have accessible cash set aside to use in the case of a financial emergency. Most experts recommend at least six months of income to tide yourself over. Just make sure any use of this money truly is for an emergency.

Home Equity Loan

Home equity loans are for people who have a fair amount of equity in their homes. It’s essentially a second mortgage, but the repayment term lasts a much shorter period. The pro is that the interest you pay on the loan is tax-deductible.

401(k) Taxable Withdrawal

Here’s another way to utilize your 401(k) funds. Instead of taking a loan, you may be able to take out a hardship withdrawal. If you’re using the money for medical needs, you may be able to avoid the 10% penalty, although you’d still have to pay income taxes on whatever you take out.

IRA 72(t) Withdrawal

IRA 72(t) withdrawals offer an alternative to borrowing from your 401(k), especially for those with substantial IRA funds. Under IRS Rule 72(t), you can take early, penalty-free withdrawals from your IRA, provided the withdrawals are part of a series of substantially equal periodic payments (SEPPs). These payments must continue for 5 years or until you reach age 59 ½, whichever is longer.

This option requires careful calculation, as the SEPPs must be based on one of three IRS-approved methods. It’s important to note that once started, the 72(t) payments must be taken as scheduled, and any deviation can result in retroactive penalties. Consider consulting a financial advisor to understand how these withdrawals could affect your long-term retirement savings and tax situation.

Bottom Line

Deciding on a 401(k) loan involves balancing immediate financial needs with long-term retirement goals. While it offers immediate liquidity and potentially lower interest rates, the impact on your future savings and the risks associated with job changes and loan defaults must be carefully weighed.

Financial planning is a dynamic process, requiring you to consider both present circumstances and future aspirations. A 401(k) loan can be a strategic tool in your financial toolkit, but it demands careful consideration and thorough understanding of its terms and consequences.

Before proceeding, explore all financial options, assess the stability of your employment, and consider seeking advice from a financial advisor. The key is to make an informed decision that aligns with both your immediate financial needs and your long-term retirement objectives.

Frequently Asked Questions

How do I take out a loan from my 401(k)?

Most 401(k) plans allow you to borrow up to 50% of your vested account balance, up to a maximum of $50,000. You will need to fill out a loan application and provide documentation of your loan purpose and repayment schedule.

What are the repayment terms of a 401(k) loan?

Repayment terms vary by plan, but you are typically given 5 years to repay the loan. However, if the loan is used to purchase a primary residence, the repayment period can be extended to 10 years. You must make regular payments that include both principal and interest.

Does taking a 401(k) loan affect my credit score?

No, a 401(k) loan is not reported to credit bureaus and therefore has no direct impact on your credit score. However, it’s important to manage these loans responsibly as they can affect your long-term financial health.

Are there any penalties for defaulting on a 401(k) loan?

Yes, if you default on a loan from your 401(k) plan, you will be subject to taxes and penalties on the amount of the loan.

Can I take a 401(k) loan if I already have an outstanding loan from the same plan?

This depends on your plan’s rules. Some plans allow multiple loans, while others restrict the number of outstanding loans. Check with your plan administrator for details.

Are there any restrictions on how I can use the money from a 401(k) loan?

Yes, most plans restrict the use of loan proceeds to specific purposes, such as purchasing a primary residence or paying for college tuition and expenses.

Can I make extra payments on my 401(k) loan?

Yes, you can make extra payments on your 401(k) loan. This can help you pay off the loan sooner and reduce the amount of interest you pay.

What happens if I cannot repay my 401(k) loan due to financial hardship?

If you face financial hardship and can’t repay your loan, it may be considered a distribution and subject to taxes and penalties. This is a risk you should consider before taking a loan.

Lauren Ward
Meet the author

Lauren is a personal finance writer who strives to equip readers with the knowledge to achieve their financial objectives. She has over a decade of experience and a Bachelor's degree in Japanese from Georgetown University.