How Does a 401(k) Loan Work?

Can I Borrow From My 401(k)?

Most (but not all) 401(k) plans allow participants to borrow from their accounts and use the funds however they want. Unlike hardship withdrawals, which require you to demonstrate a specific need for the money, there are no hardship requirements for taking out a 401(k) loan. Because you're borrowing, not withdrawing money, you must repay the loan with interest. If you don't, unpaid amounts are subject to income tax and possible penalties.

Learn more: 401(k) Loan vs. Personal Loan: How to Choose

How to Borrow From Your 401(k)

If your plan allows it, taking out a loan from your 401(k) is relatively simple. Here's a brief overview of the process.

1. Confirm Plan Eligibility

Almost 80% of 401(k) plans offer loans, according to Manulife John Hancock Retirement. If your plan allows loans, you can borrow up to the maximum amount allowed by your plan administrator.

2. Determine Loan Details

Each plan has its own repayment terms and loan limits. Before applying, find out how much you can borrow and what your repayment options are to see if a 401(k) loan meets your needs.

3. Complete the Application

You can get details about applying for a 401(k) loan from your human resources department or plan administrator. You may be able to set up a loan via the website you use to manage other 401(k) tasks, such as changing contribution amounts and selecting funds to invest in.

4. Receive Funds

It typically takes about seven to 10 business days to process a 401(k) loan application. If your application is approved, you may receive the loan proceeds via electronic funds transfer or check.

5. Make Regular Payments

Loan payments are calculated based on your interest rate and repayment term. It's crucial to repay your loan on time, just as you would if you were borrowing money from a lender. If your loan goes into default, the amount you borrowed is treated as a distribution instead of a loan, taxed as income and may be subject to penalties.

Learn more: Should I Withdraw Money From My 401(k) or IRA?

How Much Can I Borrow From My 401(k)?

Under federal law, the maximum amount you can borrow is $50,000, regardless of how much you have in your account. If your vested balance is less than $100,000, the most you can borrow is $10,000 or 50% of the vested amount, whichever is greater.

However, individual plans may have different limits, so it's best to check with your employer or plan administrator if you're considering a 401(k) loan.

Tip: If you're married, you may need your spouse's consent to borrow from your 401(k).

401(k) Loan Repayment Terms

Under the law, you must make a minimum of one principal and interest payment each quarter. You can make more frequent payments to pay back your loan sooner, and there generally isn't a penalty for repaying your loan before the end of the term.

You must repay your loan within five years, unless you're using the money to purchase your primary residence. If you use the loan to buy a home, your plan administrator may extend the repayment timeline, but it varies by plan.

Interest rates on 401(k) loans are determined by the fund administrator and are usually the current prime rate, but may be higher.

Tip: If you lose or change jobs, you may have to repay your remaining loan balance right away. If you can't come up with the cash that quickly, you can avoid taxes and penalties by depositing the outstanding loan balance in an individual retirement account (IRA) or other eligible retirement plan before your federal income taxes are due for the year.

401(k) Loan vs. Withdrawal

When you take out a 401(k) loan, you must repay the money, with interest, just as you would other types of loans, such as a mortgage or auto loan. If you repay what you borrowed according to the loan terms, the money isn't taxed or subject to penalties.

When you make a withdrawal from your 401(k), you take the money out of your account with no plan to repay it. Withdrawals are subject to income taxes, and if you withdraw money from your account before age 59½, you must pay an additional 10% penalty, with a few exceptions.

Learn more: What Are the Consequences of Early Retirement Withdrawals?

Will a 401(k) Loan Affect My Credit?

Getting a 401(k) loan won't directly affect your credit scores. Since you're borrowing money from yourself, plan administrators don't conduct hard credit inquiries the way lenders do. Payments aren't reported to the three major consumer credit bureaus (Experian, TransUnion and Equifax) and aren't included in credit score calculations.

If you miss a payment or default on your loan, your credit scores won't change. However, the extra taxes and penalties you may have to pay when you default on a 401(k) loan can make it difficult to pay your other bills, which may affect your credit indirectly.

Pros and Cons of a 401(k) Loan

Getting a 401(k) loan may seem like a simple solution when you need extra cash. But it's important to consider the benefits and risks before borrowing money from your retirement account.

Should I Borrow From My 401(k)?

If you're thinking about borrowing from your 401(k), it's important to proceed with caution and a plan. When you need cash, taking out a 401(k) loan probably shouldn't be your first choice, and it shouldn't be used for discretionary spending like a big vacation. However, it may make sense if you need to cover an emergency expense, are confident you can repay what you borrow and have no other lending options.

Because you may be required to repay what you borrow right away if you change or lose your job, borrowing from your 401(k) isn't a great option if your employment status is uncertain. If you have other sources of cash or lending options, using one of those is probably a better bet than taking out a 401(k) loan.

Alternatives to 401(k) Loans

Given the potential drawbacks of borrowing from your 401(k), it's best to evaluate other options before tapping your retirement savings. Here are a few alternatives to consider.

• Dip into your emergency savings. The purpose of an emergency fund is to have cash on hand when an unexpected expense pops up. If you have money sitting on the sidelines for an emergency, using it may be a better option than borrowing from your 401(k).
• Get a 0% intro APR credit card. If you have good credit, consider taking advantage of a 0% introductory offer. If you're able to repay your balance before the promotional period ends, you can avoid paying interest altogether. If not, you may be charged interest retroactively on all of your purchases. Read the fine print carefully to make sure you understand the terms of the offer.
• Take out a personal loan. Getting a loan from a bank or credit union may be an option if you have good credit. Personal loans generally range from $1,000 to $100,000 and can be used to pay for almost anything. However, unlike a 401(k) loan, lenders conduct credit checks and report loan payments to the credit bureaus, so late or missed payments will negatively affect your credit history. Interest rates on personal loans tend to be higher than rates on 401(k) loans.

The Bottom Line

Borrowing from your 401(k) is an easy way to get cash in a pinch, but it has significant drawbacks. If you decide the benefits are worth the risks, getting a loan is simple, and if you're approved, you'll receive your money within a couple of weeks of submitting your application.

But before tapping into your retirement savings, be sure to evaluate and weigh all other options carefully. Borrowing from your 401(k) can derail your retirement savings and have long-term financial consequences that may be difficult to overcome. If you decide a 401(k) loan is right for you, continuing to make regular contributions in addition to your loan payments can help minimize the financial impact of taking out a loan.