401(k) loans: What they are and how they work

Ideally, when you contribute to a retirement account, you can leave the money invested until after you stop working. However, if you need to borrow money for an emergency or to achieve a financial goal, such as paying off high-interest debt, you might be able to take a loan from your 401(k).

With a 401(k) loan, you can get a low-rate loan without a credit check and then pay yourself back. But it’s not always a good idea. Even temporarily taking money out of your 401(k) could result in significantly lower long-term balances. And you’ll want to consider what happens if you leave your job or can’t repay the loan.

Read on to learn all about 401(k) loans. 

Key takeaways

  • If you have a 401(k) with your current employer, your plan might allow you to borrow up to $50,000 from your account. 
  • 401(k) loans don’t depend on or impact your credit scores, they may have a low interest rate and you’ll pay yourself back.  
  • Taking money out of investments could hurt your retirement savings.
  • You might have to quickly repay the outstanding balance if you leave or lose your job. 

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What is a 401(k) loan?

A 401(k) loan is a loan you borrow from yourself by withdrawing money from your 401(k). The IRS allows you to borrow up to 50% of your vested 401(k) retirement savings, with a $50,000 cap. A 401(k) loan typically has a relatively low interest rate, and you’ll generally have up to five years to repay it.

However, employers can set additional rules or requirements. And some employers don’t allow 401(k) loans.

How does a 401(k) loan work?

A 401(k) loan works differently from other loans because you’re not borrowing money from a lender. Instead, you’re making a withdrawal from your 401(k) that doesn’t have an early withdrawal penalty or tax implications. Then you’re returning the money to your account with interest. 

If your 401(k) plan allows 401(k) loans, you can request a loan from your plan administrator. Once the loan is approved, some of your investments will be sold, and you’ll receive the cash. You’ll then have to repay the loan based on the loan agreement. At a minimum, your plan has to require quarterly payments. And you must repay the loan within five years unless you use the money to purchase a primary residence. 

Your repayment could be accelerated if you leave or lose your job. In that situation, you may need to repay the full loan amount by the tax-filing deadline for the year you received the distribution. For example, if you get a 401(k) loan in 2023 and then lose your job, you have to repay the balance by April 15, 2024—or October 15, 2024, if you file for an extension. 

If you fall behind on your loan payments, the loan could be considered a taxable distribution, and you could have to pay income taxes and an early withdrawal penalty.

Pros and cons of borrowing from a 401(k)

Although everyone’s financial situation is different, there are a few general advantages and disadvantages of taking out a 401(k) loan to keep in mind: 

Pros of 401(k) loans

  • It’s easy to apply, and qualification doesn’t depend on your credit. Unlike when you apply for a loan from a lender, your income, outstanding debt and credit history might not affect your eligibility. 
  • You could get a low interest rate, and you’ll pay yourself back. A 401(k) loan accrues interest, and plan administrators generally charge the prime rate plus an additional 1% to 2%. The resulting interest rate may be lower than you could receive from a lender, and you’re paying yourself the interest.
  • You can access your 401(k) without paying taxes or penalties. As long as you repay the 401(k) loan as agreed, you don’t have to pay any income taxes or early withdrawal penalties on the money. In contrast, income taxes and penalties may apply to early withdrawals, including hardship withdrawals.

Cons of 401(k) loans

  • Your employer can charge fees and decide if and when you can take a 401(k) loan. There may be an application and an annual or monthly maintenance fee to take out and use a 401(k) loan. Your employer can also set stricter loan limits or requirements than the IRS allows.  
  • There are set 401(k) loan limits and repayment requirements. Even if your employer chooses to use the IRS’ maximum allowed limits, you might not be able to borrow as much as you could get from a traditional loan. Unless you use the money to buy a primary residence, you’ll also have to repay the loan within five years, which could lead to high monthly or quarterly payments. Also, you may have to quickly repay the loan in full if you leave your job, are laid off or are fired. 
  • You’ll lose out on potential investment gains. You’re withdrawing rather than borrowing against the money in your account—which means you’ll need to sell some of your investments and lose out on their potential gains. The long-term effect on your retirement could be especially bad if you’re taking out a loan while markets are down and buying back in when they’re up. Also, repayments aren’t considered contributions. And some employers won’t let you make new contributions while you have a loan, which means you might miss out on a 401(k) match.
  • The unpaid balance will be considered a distribution if you don’t repay the loan on time. If you can’t afford your 401(k) loan payments, the unpaid portion could be treated as an early withdrawal. You may need to include it in your taxable income for the year and pay an early withdrawal penalty unless you qualify for an exception.

How to take a loan from a 401(k)

You can only take out 401(k) loans from a 401(k) that you have with your current employer. And even then, the company has to allow loans and can approve or deny your application. Additionally, you might need your spouse’s approval if you’re married. 

If you want to get a 401(k) loan, you’ll apply with your plan administrator—the person or company that manages your 401(k) plan. You may be able to review the rules and quickly apply online. However, it may take several business days, or even a few weeks, for your plan administrator to review your application and distribute the funds. 

Although your credit doesn’t affect your ability to get a 401(k) loan, your plan administrator could deny your loan request for other reasons. For example, it might not approve you for a loan if you have an outstanding 401(k) loan.

When you’re self-employed and have a solo 401(k), you can approve your own 401(k) loan request. But you’ll still need to follow the IRS requirements, and some solo 401(k) loan providers don’t support 401(k) loans. You might also have retirement savings in an IRA, but the IRS doesn’t allow you to take IRA loans.

Alternatives to a 401(k) loan

Although using 401(k) loans can sometimes be a good idea, compare your financing options to see if a traditional loan might make some sense. Some alternatives to a 401(k) loan include the following: 

Personal loan

A personal loan is an installment loan that you qualify for based on your income, debt and credit. These loans often have fixed interest rates and require monthly payments over the loan’s term—commonly three to seven years. If you have excellent credit, you might qualify for a low interest rate that’s similar to the rate you could get with a 401(k) loan. However, those with poor credit may find it difficult to qualify for a personal loan with favorable terms.

Home equity loan (HEL)

An HEL is an installment loan that you can take out using your home as collateral. Home equity loans can offer low interest rates and large loan limits—if you have a lot of equity in your home. The interest payments might be tax deductible if you use the funds to buy, build or substantially improve your home. However, because it’s a second mortgage, you risk foreclosure if you can’t repay the loan.  

Home equity line of credit (HELOC)

A HELOC is a line of credit that’s secured by your home. The HELOC gives you the option of taking out a loan up to your account’s credit limit. A HELOC can be helpful if you’ll need to take out several loans in the coming months or years. Similar to home equity loans, the interest might be deductible in certain circumstances. But there’s also the same risk that comes with using your home as collateral.

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401(k) loan FAQ

Here are some frequently asked questions about 401(k) loans:

The IRS 401(k) loan limits allow you to borrow up to $10,000 or 50% of your vested account balance—whichever is higher—with a maximum loan amount of $50,000. Although you can take out more than one 401(k) loan at once, the maximum combined outstanding loan limit may be lower than $50,000 if you take out more than one loan during a 12-month period. Your employer may also set lower limits than the IRS allows. 

A 401(k) loan doesn’t require a credit check, which means applying won’t lead to a new credit inquiry. Employers also don’t report the loan to the credit bureaus, so repaying the loan won’t help your credit score. Missing payments also won’t hurt your credit, but if you don’t repay the loan, you may need to pay additional income taxes and an early withdrawal penalty when you file your annual tax return. 

As with other types of loans, you don’t have to pay income taxes on the money you receive from your 401(k) loan. However, that might change if you miss loan payments and default on the loan. When that happens, the 401(k) loan could be considered an early distribution and may be subject to income taxes and penalties. 

Your employer will know if you take out a 401(k) loan. You can only take 401(k) loans from a 401(k) plan with your current employer, you need to apply with your plan administrator and you might repay the loan with payroll deductions. But remember, it’s already your money, and you can choose how you want to use it. 

401(k) loans in a nutshell

If you have savings in your 401(k) and your plan allows you to take a loan, you might be tempted to borrow the money when you’re short on cash. Although a 401(k) might be a helpful option—especially if you can’t qualify for a good loan elsewhere—consider the impact on your long-term savings.

Also, remember that there are other financing options to consider outside of 401(k) loans, including personal loans. Check out Capital One’s guide on how to get a personal loan with fair credit.

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