What Is a 401(k) Loan?

Taking out a 401(k) loan is a popular option for borrowing, and while it can be cost-effective, that doesn’t mean it’s right for you.

Written by Hilary Collins / July 12, 2022

Quick Bites

  • A 401(k) loan is a loan borrowed from your retirement plan and works similarly to a traditional personal loan.
  • These loans have limits on the total you can borrow—either $50,000 or half of your vested balance, whichever is less.
  • Compare interest rates and make sure that you understand the implications of borrowing from your retirement fund before you take the plunge.

If you’re considering a 401(k) loan, you’re far from alone. Almost 40% of 401(k) participants will take out a 401(k) loan in a five-year timespan, according to research by the Wharton Pension Research Council.[1]

However, taking out a 401(k) loan before you understand all of the financial implications can set your retirement savings back significantly. Let’s take a look at what a 401(k) loan is, how the process works and how to determine whether it’s the right choice for you.

Inside this article

  1. What is a 401(k) loan?
  2. How does a 401(k) loan work?
  3. Is a 401(k) loan right for me?
  4. FAQ

What is a 401(k) loan?

A 401(k) loan is a loan taken from your retirement plan. According to the Internal Revenue Service, the maximum amount you can borrow is either 50% of your vested account balance or $50,000—whichever amount is less.[2] Not all retirement accounts offer loans, so you’ll need to check with your plan sponsor or by reviewing the plan description.

  • Example: If your vested account balance is $90,000, you can take a 401(k) loan of $45,000, because 50% of your vested balance is less than $50,000.

The terms of a 401(k) loan will look similar to a personal loan of the same size, according to the Financial Industry Regulatory Authority (FINRA).[3] You’ll agree to a principal amount, the term of the loan, the interest rate and other fees and conditions. The interest rates are based on the market, so those will likely be similar to what you would see when applying for a personal loan.

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The term of the loan—or how long you’ll be repaying it—is generally five years. However, if you’re taking out the loan in order to buy a home, you’ll be able to extend that for up to 25 years.

How does a 401(k) loan work?

First of all, you’ll review your plan to see if they offer loans and note if there are any special conditions or limits. You should carefully review the terms to make sure you fully understand them. You can consult your 401(k) plan representative, human resources at your workplace or a financial advisor if you need clarification on any of the fine print.

Once you decide this is the right option for you, you’ll fill out the paperwork. Many 401(k) plan providers have simplified online processes these days, thank goodness. FINRA notes that you’ll rarely be turned down, as you’re borrowing from your own savings. Once approved, your funds will be deposited in your account or sent via check.

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Now you just have to focus on making your payments on time. Many 401(k) loans allow you to make payments via payroll deductions, which makes repayment simple as long as you remain employed.

Is a 401(k) loan right for me?

Deciding to borrow from your 401(k) can be a tough call, but it comes with clear pros and cons. Let’s outline some of the considerations.

Cons:

  • 401(k) loans have a higher percentage of borrowers who struggle to pay them back than personal loans. About 10% of borrowers from 401(k) plans defaulted, compared to about a 3% delinquency rate among borrowers of personal loans.[4,5].

    Tip

    Research from the National Bureau of Economic Research shows that the high number of defaults on 401(k) loans is driven by borrowers whose employment ended while their 401(k) loan was still outstanding.

  • Another job-related hurdle to 401(k) loans is that if you leave your place of employment, you might be required to pay the loan off entirely in a short period of time. You can see why that drives so many borrowers to default.[6]

  • Of course, one of the biggest drawbacks to 401(k) loans is the hit to your retirement savings: any money you take out isn’t collecting interest for the future. This can really add up over the years.

  • There are also tax implications to 401(k) loans. One of the ways that 401(k) plans are such an effective retirement savings tool is that they’re tax-deferred—that is, you don’t pay income tax on the money up front. Instead, you only pay income taxes when you withdraw the money. So when you borrow from your 401(k), you’re taking untaxed dollars and repaying them with after-tax dollars—and you’ll have to pay taxes again when you withdraw from your 401(k) for retirement.

  • If you become delinquent or default on your loan, the tax drawbacks can multiply. The IRS notes that if a 401(k) loan isn’t repaid according to the terms of the plan, it’s taxed as a distribution—that’s 10% in additional taxes if you’re not 59.5 years or older.

  • Finally, the terms on 401(k) loans aren’t always better than a personal loan, mortgage, or other line of credit. Make sure you really understand the fine print of your 401(k) loan before you sign off on it.

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Pros:

  • If you have a low credit score, a 401(k) loan might offer a much lower interest rate than you would get from traditional lenders.

  • The interest you pay on the loan goes back into your retirement account, FINRA notes.

  • As long as you follow all of repayment requirements, 401(k) loans aren’t taxed.[7]

  • 401(k) loans have no impact on your credit score: applying for one doesn’t require a hard credit inquiry that might cause a dip in your credit score, and being delinquent or defaulting won’t hurt your score either—just your retirement account.[8]

  • Research from the National Bureau of Economic Research found that 401(k) loans are “neither a blessing or a bogeyman,” but can be a useful financial tool if used wisely.[9]

Like all debt, 401(k) loans can be disastrous if not approached carefully, but can improve your overall financial situation if used wisely. Talk to a financial advisor, review the terms of the loan closely, and make sure this is the right choice for you.

FAQ

How long does it take to get a 401(k) loan?

This will depend on your plan provider and the process they have in place. If they have an online system and can disburse the money directly into your bank account, the process will likely be a lot faster than if you have to mail in paperwork, wait for a paper check, and deposit it.

How can I pay off a 401(k) loan?

You will have to refer to the specific terms of your retirement plan, but generally speaking, you repay a 401(k) loan in the same way you do any other loan. There is the added benefit of being able to set up automatic payments from your paycheck to simplify the process. And there’s no downside or penalty to paying off your 401(k) early!

Article Sources
  1. “Borrowing from the Future: 401(k) Plan Loans and Loan Defaults,” 2014, Wharton Pension Research Council. https://pensionresearchcouncil.wharton.upenn.edu/publications/papers-2018/borrowing-from-the-future-401k-plan-loans-and-loan-defaults/
  2. “Retirement Topics - Plan Loans,” April 27, 2022, Internal Revenue Service. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-loans
  3. 401(k) Loans, Hardship Withdrawals and Other Important Considerations,” Financial Industry Regulatory Authority. https://www.finra.org/investors/learn-to-invest/types-investments/retirement/401k-investing/401k-loans-hardship-withdrawals-and-other-important-considerations
  4. “Borrowing from 401(k)s,” June 2015, National Bureau of Economic Research. https://www.nber.org/bah/2015no2/borrowing-401ks
  5. “Recent Vintage Loans Perform Well Even as More Non-Prime Consumers Secured Credit in Second Half of 2021,” Feb. 2, 2022, TransUnion. https://newsroom.transunion.com/recent-vintage-loans-perform-well-even-as-more-non-prime-consumers--secured-credit-in-second-half-of-2021/
  6. “Considering a loan from your 401(k) plan?” April 27, 2022, Internal Revenue Service. https://www.irs.gov/retirement-plans/considering-a-loan-from-your-401k-plan-2
  7. “401(k) Resource Guide - Plan Participants - General Distribution Rules,” Jan. 20, 2022, Internal Revenue Service. https://www.irs.gov/retirement-plans/plan-participant-employee/401k-resource-guide-plan-participants-general-distribution-rules#tax-on-early-distributions
  8. “How to Borrow Money from Your 401(k),” April 10, 2019, Experian. https://www.experian.com/blogs/ask-experian/how-to-borrow-money-from-your-401k/
  9. “The Impact of 401(k) Loans on Savings,” Sept. 29, 2010, National Bureau of Economic Research. https://www.nber.org/sites/default/files/2020-08/orrc09-05.pdf

About the Author

Hilary Collins

Hilary Collins

Hilary is an experienced finance writer with a passion for turning complicated topics into readable stories with real-world takeaways.

Full bio

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