How Do 401(K) Loans Work?

When facing unexpected expenses, some individuals turn to their 401(k) retirement plan as a potential source of funds. Unlike traditional loans, a 401(k) loan allows you to borrow from your own retirement savings without a credit check, but there are important rules to follow.

While 401(k) loans can provide quick access to cash, they come with specific repayment terms and risks that could impact your long-term savings. The interest rate for a 401(k) loan is usually a point or two higher than the prime rate, but it can vary. By law, individuals can borrow the lesser of $50,000 or 50% of the total amount of the 401(k) in a 12-month period.

Here’s how they work, the pros and cons, and what to consider before borrowing from your retirement account.

Key Takeaways

• A 401(k) loan can provide quick access to cash for unexpected expenses.
• You can borrow up to 50% of your 401(k) balance, or $50,000, whichever is lower.
• Loans must generally be repaid within five years, plus interest.
• Unlike a 401(k) withdrawal, loans don’t incur taxes or penalties, and repayments (including interest) go back into your account.
• If you leave your job, the loan may be due in full in a short time frame.

How a 401(k) Loan Works

Many 401(k) plans allow you to borrow a portion of your retirement savings tax-free, usually up to $50,000 or 50% of your balance, whichever is less. If your vested account balance is under $10,000, you can borrow up to $10,000.

Unlike traditional loans, you don’t need to go through a lender or have your credit checked, making it easier to access funds quickly. The interest rate is typically one to two percentage points above the prime rate.

You may also be able to take out more than one loan at a time, provided the total amount doesn’t exceed the plan’s allowed maximum.

IRS regulations usually require repayment within five years, though you can pay off the loan earlier without a prepayment penalty. Most plans allow loan repayments via payroll deductions, but these are made with after-tax dollars. (Note that loan repayments don’t count as contributions to the plan.)

Note

If you’re married, some plans may require your spouse’s consent before taking out a loan.

Pros and Cons

Like any other type of debt, there are pros and cons involved in taking out a 401(k) loan. Some of the advantages include convenience and the receipt of the interest paid into your account. If you take out a 401(k) loan and you pay 7% interest on it, for example, that 7% is going back to your 401(k) because that is where the money came from. In fact, if you pay back a short-term loan on or even ahead of schedule, it may have a negligible impact on your retirement savings.

One major disadvantage of a 401(k) loan is the loss of tax-sheltered status in the event of a job loss. If you take out a loan on a 401(k) and you lose your job or change jobs before the loan is fully repaid, there is a period in which the full amount of the loan must be repaid. If the loan is not fully repaid at the end of the grace period, not only does the amount become taxable, an additional 10% penalty is charged by the Internal Revenue Service (IRS) if you are under the age of 59½.

Advisor Insight

Timothy Baker, CFP®, MBA
WealthShape LLC, Windsor, Conn.

This may sound like a good option for those needing funds, but there are a few things to consider.

The loan will have interest attached to it. While that interest payment does go back into your account, consider the opportunity cost of what you could have earned if the loan amount was invested.

Depending on the stipulations of your 401(k) plan, you may or may not be able to make additional contributions while you’re in the process of paying back your loan.

Other options to consider are hardship withdrawals, though they have significant conditions according to the IRS code, or a home equity loan.

Another possibility is taking a series of equal periodic payments, which can help to avoid the 10% early withdrawal penalty. Withdrawals must last a minimum of five years or until age 59½.

Can I Access a 401(k) Loan With a Debit Card?

While some earlier plans allowed 401(k) loans via debit or credit cards, the SECURE Act (signed into law on December 20, 2019) strictly prohibits this. The act was designed to improve retirement benefits in the U.S. and restricts using cards to access 401(k) loan funds.

What’s the Difference Between a 401(k) Loan and a Hardship Withdrawal?

A 401(k) loan lets you borrow funds from your retirement account and repay them with interest. In contrast, a hardship withdrawal allows you to take funds for specific immediate needs, such as medical expenses or home repairs. However, hardship withdrawals are subject to income tax and may incur a 10% penalty if taken before age 59½. Unlike a loan, hardship withdrawals cannot be repaid to the plan.

How Much Interest Do You Pay on a 401(k) Loan?

Typically, retirement plans charge the current prime rate plus 1% or 2% in interest on 401(k) loans. That interest, along with your repayments, is deposited into your account. However, keep in mind that you’re paying with after-tax funds.

The Bottom Line

A 401(k) loan can be a good way to access funds, but it’s crucial to understand the rules and repayment terms. Before borrowing, review your plan’s specific requirements and try to repay the loan as quickly as possible to minimize its impact on your retirement savings.