91Ӱ

BLUEPRINT

You might be using an unsupported or outdated browser. To get the best possible experience please use the latest version of Chrome, Firefox, Safari, or Microsoft Edge to view this website.

Advertiser Disclosure

Editorial Note: Blueprint may earn a commission from affiliate partner links featured here on our site. This commission does not influence our editors' opinions or evaluations. Please view our full advertiser disclosure policy.

Key points

  • 401(k) loans allow you to borrow a portion of your retirement fund balance.
  • Interest charges on 401(k) loans go back into your account.
  • Failing to repay the loan or leaving your job can have tax consequences.

Retirement plans, including 401(k)s, are among the most valuable assets workers hold. Thirty-four percent of household wealth is held in these accounts, according to 2021 Census Bureau data. That’s more than home equity, which comes in at 28.5%.

While money in a 401(k) account is intended for retirement, you can take out a portion of your balance as a loan. Doing so has benefits over other forms of lending. But 401(k) loans are not risk-free and should be used sparingly.

What is a 401(k) loan?

A 401(k) loan involves taking money out of a 401(k) temporarily. Interest charged on the loan is paid back into the account along with the principal.

The IRS allows you to borrow the lesser of 50% of your vested balance or $50,000. But if 50% of your vested balance is less than $10,000, you may be able to borrow up to $10,000.

While the IRS regulates 401(k) loans, employers decide whether to allow them.

“Some employers don’t want their employees to treat (401(k)s) like piggy banks, so they don’t allow (loans),” said Todd Feder, vice president and senior retirement plan consultant at Girard, a wealth advisory firm backed by Univest.

But he noted that prohibiting loans could discourage workers from contributing to retirement plans. “People are hesitant to put money away if they think it’s locked up,” he said.

How does a 401(k) loan work?

Assuming your employer allows 401(k) loans, the process is usually straightforward. You may need to contact your plan administrator to request a loan. But some plans allow you to do so in your online account.

Funds can be received in two or three days, according to Feder, and repayment is made via automatic payroll deductions. A five-year repayment term is the norm.

Employers set the interest rate. The prime rate plus 1% is common, said Michele Martin, president of Prosperity, an EisnerAmper company. Interest paid on the loan is deposited into the 401(k) account, so you’re essentially paying yourself.

Benefits of a 401(k) loan

The following benefits make 401(k) loans popular with some borrowers:

  • Easy application process and minimal fees. A 401(k) loan does not require a credit check or lengthy application process. Fees often run from $75 to $125, according to Feder.
  • Convenient repayment through payroll deductions. Since loan payments are made as payroll deductions, repayment is automatic. You need not worry about missing payments or paying late fees.
  • Interest goes back into your account. “I’m a huge proponent of making yourself the bank,” said Kris Whipple, partner and financial advisor at Kristopher Curtis Financial. If you must take out a loan, one where you pay interest to yourself may be preferable to other options.

Drawbacks of a 401(k) loan

Of course, 401(k) loans also come with significant downsides:

  • Paying back pretax dollars with after-tax dollars. If you have a traditional 401(k), you do not pay taxes on your contributions. But when you repay a 401(k) loan, you use after-tax dollars. Depending on your tax bracket, that could be the equivalent of needing $125 to repay $100, Feder said, meaning 401(k) loans may be more expensive than you think.
  • Loss of compounding gains. Another hidden cost of a 401(k) loan is the loss of compounding gains. “Essentially, you’re taking away the growth of those investments,” Martin said.
  • Loan could become taxable income and subject to a penalty. If you leave your job, you may need to repay the balance of your 401(k) loan immediately. Failure to do so results in the loan becoming a taxable distribution. You will also incur a 10% penalty if you are younger than 59½.

Tip: You can avoid the immediate income tax consequences by rolling the 401(k) loan’s outstanding balance into an eligible retirement account by the federal tax deadline the following year.

When should you borrow from your 401(k)?

Experts generally caution against borrowing from your 401(k). But if you need money for an emergency, a 401(k) loan can make sense. 

“Don’t use this as fun money,” Whipple said. “Use this as needed money.”

Here’s when you might want to borrow from your 401(k).

You need money quickly

If you have an emergency and need money immediately, you might not be able to wait for a traditional loan application to be reviewed and approved. With a 401(k) loan, you could have cash in your bank account in a few days.

Your credit is not good enough to qualify for another loan

“One of the benefits of a 401(k) loan is that there (are no) credit qualifications or applications,” Martin said. If poor credit would make it difficult to borrow elsewhere or would result in a high interest rate, a 401(k) loan may be your best option.

You have no other option

If you have no savings and few lending choices, a 401(k) loan can provide an escape hatch from a difficult financial situation. But it is best to use this option as a last resort.

When should you not borrow from your 401(k)?

There are also times when you should not borrow money from your retirement account.

You want money for a discretionary purchase

“I would not want to be looking at a 401(k) loan to take a vacation,” Feder said. If you are going to dip into your 401(k) account and risk reducing your retirement nest egg, make sure it is for something you need, not something you want.

The future of your job is uncertain

If you leave your job and are unable to repay your loan, you could find yourself on the hook for a large tax bill. So think twice about taking out a 401(k) loan if you plan to change jobs within five years or the prospect of layoffs is looming at your company.

You need a lot of money

Since 401(k) loans are capped at the lesser of 50% of your vested balance or $50,000, they may not be suitable for major purchases. And taking out a large sum could result in payments that squeeze your budget.

401(k) loan repayment rules

While employers control certain aspects of 401(k) loans, the IRS mandates the following repayment rules:

  • Loans must be repaid in five years unless they are used to purchase a primary residence.
  • Payments must be made at least quarterly.
  • An employee who leaves their job may be required to repay their outstanding loan balance immediately. If they do not, it is considered a taxable distribution and a penalty may apply. The worker can avoid the immediate income tax consequences by rolling over the outstanding balance to an eligible retirement account by the following year’s federal tax deadline.

401(k) loan vs. 401(k) withdrawal: What’s the difference?

If you want to take money from your 401(k) account, a withdrawal is another option. Loans have to be repaid, but withdrawals do not.

With a withdrawal, you remove money from your retirement fund permanently. That can be costly in more ways than one. First, depending on the amount, the withdrawal could have a serious effect on the account’s long-term balance. Second, money taken from a traditional 401(k) is taxed as income and may be subject to a 10% penalty if you are younger than 59½.

The penalty may be waived in some cases, including for certain hardship distributions. Hardship distributions must be due to an immediate and heavy financial need and limited to the amount necessary to satisfy that financial need, according to the IRS.

Exceptions to the 10% penalty include:

  • Up to $5,000 per child for qualified birth or adoption expenses.
  • Total and permanent disability of the plan participant.
  • The lesser of $10,000 or 50% of the account for victims of domestic abuse by a spouse or domestic partner.
  • Unreimbursed medical expenses in excess of 7.5% of adjusted gross income.
  • Certified terminal illness of the plan participant.

Tip: Some plans allow early withdrawals when no hardship exists.

Alternatives to borrowing from your 401(k)

Instead of raiding your retirement fund, consider using one of the following options when you need extra money.

Home equity line of credit

Next to retirement accounts, home equity is the largest source of wealth for 91Ӱ households.

“I think a home equity line of credit can be a good vehicle to have in place as a safety net,” Martin said. HELOCs allow homeowners to borrow money against their home equity as needed. Many have relatively low interest rates and longer repayment terms that can result in affordable monthly payments.

Personal loan

Applying for a personal loan is more involved than taking out a 401(k) loan. But you may find competitive rates from local banks and credit unions. Online lenders may also process applications quickly and fund loans as soon as the next business day.

Emergency savings

You should have enough money in an emergency fund to cover three to six months of expenses. That will help you avoid going into debt to cover unexpected bills. If you don’t already have an emergency fund, make building one a priority. 

Is a 401(k) loan right for you?

Borrowing from your 401(k) may seem like a logical way to get money. After all, there are few fees, and you pay interest to yourself. But Feder noted that people can fall into a cycle of taking out multiple loans, resulting in meager retirement savings.

Before taking out a 401(k) loan, explore other options and consider whether you really need the money. Borrowing money to repair or replace a nonrunning car may make sense, for instance, while doing the same to upgrade a reliable vehicle may not.

If you are not sure whether a 401(k) loan is right for you, consult a financial advisor.

Frequently asked questions (FAQs)

If you default on your 401(k) loan payments, the outstanding balance becomes a taxable distribution. That means you will owe income tax on the balance. If you are younger than 59½, you will also pay a 10% penalty.

While you can leave your job, the outstanding balance on your 401(k) loan may be due immediately. If you fail to repay it, you will owe income tax on the balance plus a 10% penalty if you are younger than 59½. 

You can roll the balance into another eligible retirement account, such as an IRA, by the federal tax deadline the following year to avoid the immediate tax consequences.

Employers set the interest rates on 401(k) loans. The prime rate plus 1% is common. But you should check with your plan administrator to determine the cost of loans from your account.

Blueprint is an independent publisher and comparison service, not an investment advisor. The information provided is for educational purposes only and we encourage you to seek personalized advice from qualified professionals regarding specific financial decisions. Past performance is not indicative of future results.

Blueprint has an advertiser disclosure policy. The opinions, analyses, reviews or recommendations expressed in this article are those of the Blueprint editorial staff alone. Blueprint adheres to strict editorial integrity standards. The information is accurate as of the publish date, but always check the provider’s website for the most current information.

Maryalene LaPonsie has been writing professionally for nearly 25 years and specializes in personal finance, retirement, investing and education topics. In addition to 91Ӱ Blueprint, her work has been featured on Forbes Advisor, 91Ӱ News & World Report, Money Talks News, MSN and elsewhere on the web.

Joel Anderson

BLUEPRINT

Joel Anderson is a business writer who has been living and working in Los Angeles for over a decade. His work has appeared on sites like MSN.com, GoBankingRates and Equities.com, writing about subjects ranging from basic investing knowledge to tech start-ups. He’s focused on spreading financial literacy with his work, helping more people learn how to make their money work for them.

Hannah Alberstadt is the deputy editor of investing and retirement at 91Ӱ Blueprint. She was most recently a copy editor at The Hill and previously worked in the online legal and financial content spaces, including at Student Loan Hero and LendingTree. She holds bachelor's and master's degrees in English literature, as well as a J.D. Hannah devotes most of her free time to cat rescue.