401(k) Loans: What They Are and How They Work
8 MIN READ
Published November 23, 2023 | Updated February 08, 2024
When you contribute to your 401(k) account, you should ideally keep the money invested until you retire. However, if you have high-interest debt that you’d like to pay off or an emergency, you may be able to use the funds in your retirement account.
A 401(k) loan is a low-interest-rate loan that you can borrow against your 401(k) without a credit check. The loan amount and interest are paid back to your account. However, any money you take out of your account can lower your balance and impact your savings goals.
What Is a 401(k) Loan?
A 401(k) loan involves borrowing money against your retirement savings. When borrowing against a 401(k), the principal and interest you repay are deposited back into your account. Essentially, this means you’re borrowing from yourself.
Taking out the loan doesn’t involve a credit check, so it’s often a good option for borrowers with a low credit score who don’t qualify for traditional personal loans. The interest rate is usually the prime rate plus 1%-2%. Due to these loans' low interest rates, using a 401(k) to pay off debt may also be a good option for those with high-interest debts.
How Does a 401(k) Loan Work?
Not all plans allow taking out a loan, so be sure to check with your plan administrator for their 401(k) rules. You’ll be able to borrow half of your vested account balance or $50,000, whichever is lower.
You’ll have to repay the amount you borrow within five years unless you use the funds to purchase a home. In that case, repayment terms will be based on the loan agreement. You’ll be required to make quarterly payments on the loan at a minimum. You may also need spousal approval in writing to take out the loan if it’s over $5,000.
How To Take Out a 401(k) Loan
Here’s how to borrow from 401(k) once you’ve decided it’s the right option for you:
- Speak to your employer to check if they allow employees to take out 401(k) loans.
- Read the fine print to find out the maximum you can borrow, interest rate, and repayment schedule.
- Fill out the application form, which is usually online.
- Once you submit the application and it is approved, your plan administrator will transfer the funds to your bank account through check or direct deposit.
Using a 401(k) Calculator
Borrowing from your 401(k) has its pros and cons, which we’ve listed below. However, before you borrow the money, it's important to ensure you’ll be able to repay it within five years. Defaulting on the loan can have serious tax consequences.
Use an online 401(k) loan calculator to see how much you’ll pay over the course of the loan in interest charges. Fill out your loan amount, interest rate, and loan term to calculate your estimated monthly payment.
Will Your Employer Know If You Take Out a 401(k) Loan?
Yes, since you’ll be taking out a loan from your employer’s sponsored plan, it's likely they’ll know. To get the loan, you’ll have to talk to your company’s HR department, and any payments you make will be through payroll deductions.
If privacy is important to you, consider speaking with the HR manager to ask them to keep your loan request confidential.
What Happens If You Can't Repay Your 401(k) Loan?
If you don’t repay your loan, your borrowed amount will be considered a distribution. 401(k) distributions are taxable, so you’ll have to pay income tax on the amount when you file your taxes.
If you took out a loan from 401(k) before the age of 59 ½, it is considered early withdrawal. This means you’ll also have to pay a 10% early withdrawal penalty if you default.
Pros and Cons of Taking a 401(k) Loan
Whether taking out a 401(k) loan is a sound financial decision will depend on your situation, but there are a few general pros and cons to remember.
- It’s easy and quick to apply and get approved for a 401(k) loan.
- You can qualify for the loan without a credit check.
- You’ll be paying yourself back when you repay the loan.
- Unlike 401(k) hardship withdrawals, you can access the funds without taxes or early withdrawal penalty as long as you repay the loan as agreed.
- Your employer may have lower loan limits or stricter requirements.
- Unless you’re borrowing to purchase a primary residence, you’ll need to repay the loan within five years.
- You may have to repay the outstanding loan balance quickly if you leave the job or are fired.
- You’ll lose out on investment gains when you take money out of your retirement funds.
- If you don’t repay the loan, you’ll have to pay taxes and an early withdrawal penalty.
Teresa Dodson, a debt expert and the founder of Greenbacks Consulting, adds her thoughts on taking out a 401(k) loan. “I would never dip into my 401(k) to pay off debts,” Dodson shares. “You can always find other ways to either pay down your debt or negotiate on debt. Your 401(k) is your retirement. Don't turn it into another debt owed,” Dodson advises.
Who Is Eligible for a 401(k) Loan?
Unlike most other types of traditional loans, there aren’t many qualification requirements for 401(k) loans. Your plan must offer the option of borrowing, and you must have a vested balance in the plan.
If your company offers employer matching benefits, they may require you to stay employed for a few years before your funds are fully vested. Additionally, you’ll need written spousal approval to qualify for the loan if you’re married.
Is There a Limit to a 401(k) Loan?
The IRS has established loan limits, but your employer may also have rules about how much you can borrow from your 401(k). Typically, you can borrow 50% of your vested balance or $50,000, whichever is lower.
If your vested balance is less than $10,000, you may still be able to borrow $10,000. In some cases, your employer may allow you to borrow more than one loan, but the total amount of all loans can’t exceed these loan limits.
Alternatives to a 401(k) Loan
Although 401(k) loans may be a good idea in some situations, if your plan doesn’t offer the option, there are other alternatives to consider instead of canceling your 401(k) and cashing out.
Other Loan Options
Personal loans can be a good way to borrow money without jeopardizing your retirement funds. You may be able to get the money within one business day after approval, and repayment terms can be longer than five years in some cases.
You can also try a home equity line of credit or HELOC if you own a home with enough equity to borrow against. You can withdraw as much as you need within your approved limit whenever you want.
Another option is a home equity loan, which is different from a HELOC. Home equity loans typically have a lower interest rate compared to personal loans. However, if you default on the loan, you risk foreclosure.
Saving and Budgeting Alternatives
One way to avoid taking out a 401(k) loan is using your emergency funds to cover unexpected expenses. If you have any other investments in brokerage accounts or savings accounts, this can be a good way to avoid interest rates and fees.
You can also try to free up cash in your budget by temporarily lowering your 401(k) contribution each month, by reducing discretionary spending, or by refinancing or consolidating loans to get lower interest rates.
What To Do Next if You’re Considering a 401(k) Loan
Remember that a 401(k) loan is not the only option available. Explore all possibilities and compare the alternatives we’ve provided above before you decide which type of loan to pursue for your financial situation.
If taking out a 401(k) is the only option, be sure to understand the terms. Take a look at your budget and make sure you have a plan to repay the loan. If possible, make extra payments to pay off the amount you borrow ahead of schedule so you can replace the funds you borrowed so you’ll be on track with your financial goals.