What Is a 401(k) Loan?

Saving for retirement through your employer’s 401(k) plan has many benefits, including tax-deferred income and the possibility of company matching on your contributions. In the case of a financial emergency, you may still gain access these funds. You may qualify for a hardship withdrawal, which could subject you to taxes and a 10% early withdrawal penalty. Alternatively, you can choose to take a loan from your 401(k) account, which many find is the best option to maintain savings momentum.

Basics on Borrowing from a 401(k)

Many companies include options for borrowing against 401(k) accounts, though companies can omit this option if they wish. Specific 401(k) loan rules can vary from organization to organization based on the plan design, but some aspects are consistent across all plans when loans are available.

If the plan design permits loans, all participants are eligible to exercise this option. Since you are borrowing against your own savings, there are no credit applications required. The plan can limit the number of loans you are able to take, and often you are limited to one or two total loans. When an existing loan is repaid, you are eligible to take another. In some cases, the plan may require that your spouse sign a document indicating that he or she is aware of and agrees with your decision to take a loan.

IRS regulations set a limit on how much can be borrowed from 401(k) plans. An individual can borrow 50% of the account’s vested balance or $10,000, whichever is more, up to a maximum of $50,000. When plans permit more than one loan, the total of all loans cannot exceed these guidelines.

Understanding 401(k) Loan Terms, Interest, and Payments

When you apply for a 401(k) loan, your company is required to clearly state the terms of the loan, including the number and amount of payments and the interest rate. The maximum loan term permitted by law is five years, and your payments must be divided equally and consist of interest and principal. While many employers automatically deduct loan payments in equal amounts from each paycheck for the term of the loan, plans can allow payments to be less frequent. However, payments must be made at least once per quarter.

There are a few exceptions to these rules. If you are taking the loan to purchase your primary residence, your plan may include an option to extend the loan term. Your employer may also permit a temporary suspension of payment requirements if you take a leave of absence or you are performing military service.

Interest rates on borrowed funds are specified by your employer when the plan is designed. However, you don’t need to worry. Any interest paid goes right into your 401(k) account, so you are truly paying yourself back when you repay your loan.

What Happens When You Don’t Pay?

It is important to understand that loans are not considered distributions, unless you fail to repay them. Conversely, loan payments are not considered contributions to your account. However, if you fail to repay your loan, it will be considered a withdrawal, which means the funds will be taxed. In some cases, you may also be charged a 10% early withdrawal penalty.

If you leave your company while you have an outstanding loan, you will be given a certain amount of time to repay the full amount that you owe – usually 60 days. If you don’t repay the entire loan in the specified time period, any outstanding loan amount will be treated as a withdrawal.