401(k) Loan Rules

Written by True Tamplin, BSc, CEPF®

Reviewed by Subject Matter Experts

Updated on September 08, 2023

Get Any Financial Question Answered

What Are 401(k) Loan Rules?

401(k) loan rules govern how an individual can borrow from their 401(k) retirement savings account.

Established by the IRS and the specifics of individual plan agreements, these rules allow participants to borrow a maximum of either $50,000 or 50% of their vested account balance, whichever is less.

Loans must typically be repaid within five years through at least quarterly payroll deductions, but a longer repayment period may apply if the loan is used to buy a primary residence.

If the loan isn't repaid on schedule, it is considered a distribution, subjecting the borrower to taxes and potential penalties.

These rules aim to provide a safety net for individuals in financial hardship while protecting their retirement savings from premature depletion.

Factors of 401(k) Loan Rules

Eligible Criteria

The eligibility to take out a 401(k) loan depends on the specific terms of the participant's plan. Not all 401(k) plans allow loans and those that do often have specific guidelines around eligibility.

Generally, to be eligible, you must be a vested participant in the plan, and the loan must be for a permissible purpose.

Maximum Loan Amount

The maximum amount that a participant can borrow from their 401(k) plan is generally 50% of their vested account balance or $50,000, whichever is less.

However, if the vested account balance is less than $10,000, the participant can borrow up to $10,000.

Repayment Terms and Period

A 401(k) loan must typically be repaid within five years. The payments are made through payroll deductions, and the payments must be made at least quarterly. However, if the loan is used to buy a primary residence, the repayment period can be extended.

Interest Rates

The interest rate on a 401(k) loan is usually prime rate plus 1%. The interest paid on the loan goes back into the borrower's 401(k) account.

Loan Defaults and Consequences

If a borrower fails to repay the 401(k) loan as per the terms, the unpaid balance is considered a distribution and is subject to taxes and penalties. This can significantly impact the borrower's retirement savings and future financial stability.

Factors of 401(k) Loan Rules

Benefits of 401(k) Loan Rules

Accessibility and Convenience

401(k) loans are typically easier to access than traditional loans. There's no application process, and you don't have to prove financial hardship or meet any income requirements.

No Credit Check Required

Unlike traditional loans, 401(k) loans do not require a credit check. This can be beneficial for those with a poor credit history or those who want to avoid a hard inquiry on their credit report.

Interest Payments to Self

The interest you pay on a 401(k) loan goes back into your 401(k) account, essentially allowing you to pay interest to yourself.

Flexibility in the Usage of Funds

The funds from a 401(k) loan can be used for almost any purpose, providing flexibility for the borrower.

Risks of 401(k) Loan Rules

Potential for Retirement Savings Reduction

Taking a loan from your 401(k) plan could potentially reduce your retirement savings. This is especially true if you're unable to make contributions while you're repaying the loan or if the investments you sold to take the loan would have yielded high returns.

Tax Implications

If you fail to repay the loan as per the terms, the outstanding balance could be considered a taxable distribution. Furthermore, the money used to repay the loan is taxed twice – once when you earn it and again when you withdraw it at retirement.

Repayment Risks

If you leave or lose your job, the outstanding balance of the loan is usually due within a short period of time. If you can't repay it, it'll be treated as a taxable distribution.

Possible Penalties for Default or Early Withdrawal

If you default on the loan or can't repay it when you leave your job, not only will you face taxes, but you might also face an early withdrawal penalty if you're under the age of 59½.

Benefits and Risks of 401(k) Loan Rules

Key Considerations Before Taking a 401(k) Loan

Evaluating Financial Needs and Alternatives

Understand your financial needs and consider all available alternatives. A 401(k) loan should typically be your last resort for obtaining funds.

Impact on Retirement Savings and Future Contributions

Consider the impact of the loan on your retirement savings. Will you be able to continue making contributions? Will the loan significantly reduce your savings?

Tax and Legal Implications

Understand the tax and legal implications of taking a 401(k) loan. Consult a tax advisor or financial planner to help you navigate these complexities.

Job Security and Loan Repayment

Assess your job security. If you're unsure about your job's stability, a 401(k) loan could be risky.

Changes in 401(k) Loan Rules Over the Years

401(k) loan rules have evolved over the years, providing more flexibility for borrowers but also increasing the potential risks.

Past Rules and Policies

In the past, many 401(k) plans didn't allow loans, or they had very strict rules. However, as more employees needed access to funds, many plans began to allow loans.

Recent Amendments and Their Implications

Recent amendments to 401(k) loan rules have increased the maximum loan amount for some borrowers and extended the repayment period for loans used to purchase a home.

These changes have made 401(k) loans more attractive for some borrowers, but they also increase the potential risk of retirement savings depletion.

Conclusion

401(k) loan rules, although providing a convenient and accessible financial resource, should be approached with caution due to potential drawbacks to retirement savings.

Guided by the IRS and specific plan terms, they permit borrowing a maximum of 50% of the vested account balance or $50,000, typically repayable in five years.

While they provide benefits such as no credit checks and self-interest payment, they also hold risks like reduced retirement savings, possible tax implications, repayment risks, and penalties for default.

The flexibility in loan usage and recent amendments enhancing loan amounts and extending repayment periods can make them attractive.

However, before opting for a 401(k) loan, one must evaluate financial needs, impact on retirement savings, tax and legal implications, and job security to protect their financial future. Therefore, a 401(k) loan should typically be considered as a last resort.

401(k) Loan Rules FAQs

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.

Meet Retirement Planning Consultants in Your Area