Can I Use My 401(k) as Collateral for a Loan?

You can’t use your 401(k) account as collateral for a loan. Internal Revenue Service (IRS) regulations prohibit it. However, you may be able to borrow money from your 401(k) account.

You’ll be borrowing money from yourself, and paying it back to yourself.

Key Takeaways

• The IRS doesn’t allow you to use funds in your 401(k) account as collateral for a loan.
• Under certain circumstances, you can borrow from your 401(k) if your plan permits it.
• Taking a loan from your 401(k) comes with drawbacks that need to be considered.

Why 401(k) Funds Are Off-Limits

A 401(k) plan has some great features, such as tax-deferred status (for traditional 401(k)s), the potential for matching contributions from an employer, and a catch-up provision for older savers. 

That said, their lack of accessibility can be a drawback. The structure of a 401(k) account is different from that of a traditional individual retirement account (IRA), which is funded directly by an individual.

While an IRA is held in the name of the account holder, a 401(k) account is held in the name of the individual’s employer on the individual’s behalf. The specific 401(k) plan offered by the employer governs the circumstances under which individuals can withdraw money from the account.

Many employers only allow early withdrawals in the event of severe financial hardship.

Protection from Creditors

Moreover, 401(k) accounts are specifically protected from creditors by the Employee Retirement Income Security Act (ERISA). If a 401(k) were used as collateral for a loan, the creditor would have no means of collecting if the borrower defaulted on the loan.

Finally, taking money out of your 401(k) for any reason before you’re age age 59½ years old is a bad move financially. You could owe a 10% early withdrawal penalty in addition to income tax on the amount withdrawn. Plus, you’re damaging your long-term savings prospects by removing money that was quietly compounding in your account.

Borrowing From a 401(k)

Instead of using a 401(k) account as collateral, an individual may be able to borrow money directly from the 401(k) account. This is an option only if your employer’s plan includes a loan provision. You can request this information from your company’s human resources contact or your 401(k) plan sponsor.

After determining that a loan against your 401(k) is available, make a loan request for the amount you need up to your available limit directly to your 401(k) plan sponsor. For instance, if your 401(k) plan is managed by Fidelity Investments, direct your request there.

Once your plan sponsor processes and approves your 401(k) loan request, you receive a check or direct deposit for the amount requested, minus any loan origination fees.

Borrowing from a 401(k) has both benefits and drawbacks that need to be weighed carefully.

Pros

• You’re borrowing from yourself and repaying yourself. No bank is involved.

• The interest is substantially lower than the rates on an unsecured loan offered by a lender.

• No credit application, credit check, or underwriting is required.

Cons

• If you leave your job you’ll owe the entire loan balance immediately. If you can’t repay it you’ll owe taxes and, if you’re not at least age 59½ years old, a 10% penalty.

• You’re lowering the balance in your retirement account for a prolonged period of time. You may never fully make up the loss.

• You may be paying yourself but you’re adding another regular bill to your expenses.

Source: Internal Revenue Service

401(k) Loan Limits

The IRS allows an individual to borrow whichever is less: up to $50,000 or 50% of the account’s vested value (the amount in an individual’s 401(k) that they would receive in the event they left their job).

Important

Some plans require a spouse’s consent for a loan of more than $5,000.

While this restriction is the same for nearly all employer-sponsored plans, companies vary on which limitations are placed on the use of loan proceeds.

With some 401(k) plans, employees are only allowed to take a loan to pay for medical expenses not covered by insurance or education expenses for a spouse or child. In other cases, they can use loan funds for a down payment on a home purchase or for general financial hardship.

The 50% loan limit may not apply in the event an individual’s vested account value is less than $20,000. In that case, the individual may be allowed to borrow as much as $10,000 from the account provided the vested account value is at least $10,000.

How Would I Repay a Loan from My 401(k)?

The principal and interest on the loan will be made through payroll deductions. Note that the interest as well as the principal is going into your account, as you’re repaying yourself.

Most employers limit most loan terms to five years or less.

If you leave the job before the loan is repaid, you have until October of the following year to put the money back. If the loan is not repaid by then, it is designated as a premature distribution of funds and is subject to income taxes plus a 10% early withdrawal penalty for borrowers under age 59½.

Why Can’t I Just Withdraw Money from My 401(k)?

The IRS slaps a 10% penalty in addition to requiring full repayment of income taxes on the balance for withdrawing money from your account early. There is a long list of exceptions to the rule on the penalty, for money used for a down payment on a first home, among many other reasons. However, you would still owe all income taxes due on the money withdrawn in the year in which it is withdrawn.

What Can I Use as Collateral for a Loan?

Businesses routinely use business assets as collateral. The buildings, land, and equipment they own can be collateralized.

It’s tougher for individuals. If you own a house, a car, or some other valuable asset outright, it can be used as collateral. A regular savings account also can be used as collateral.

The Bottom Line

Your 401(k) account balance is off-limits as collateral for a loan. However, an alternative source of money is a loan from the balance in your 401(k). You’ll be loaning your own money to yourself, and repaying it to yourself.

If that interests you, check whether your 401(k) plan permits such loans.