How do 401(k) Loans Work?

How do 401(k) Loans Work?

Kim Pinnelli

by Kim Pinnelli
Senior Contributing Writer

Updated September 17, 2020
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How do 401(k) Loans Work?

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Borrowing from your 401(k) can be helpful in certain situations.

If you’ve been building up a balance in your 401(k) and you find yourself in a financial situation, you may wonder if you can borrow from it. Fortunately, you can in most situations. Your plan administrator must allow 401(k) loans, first. If they do, you’ll need to know how they work.

Understanding the Process

If you’re borrowing due to a hardship, you may be able to simply withdraw the money rather than borrow it. By law, you can borrow the lesser of 50% of your plan’s value or $50,000. Each plan may have its own maximum, though, which is less than $50,000. Always check with your plan administrator if you plan to borrow from your 401(k).

If you borrow funds, you’ll have to repay them in full. In reality, you are paying yourself; however, your plan administrator will ensure that you make your payments. You may borrow the funds for up to five years. During the term, you must make regular payments, typically on a quarterly basis.

If you leave your job, however, you will be forced to pay the loan back in full within a short time. Each plan has a different time table. If you don’t, it will count as an early distribution, which comes with its own penalties.

What are the 401(k) Loan Penalties?

Just like any other loan, there are penalties if you don’t make your payments on time. If your loan goes into default, the plan administrator may treat it as an early distribution. This carries several financial penalties. First, you will have to pay the income taxes on the money withdrawn. Plus, you’ll pay a 10% penalty tax if you aren’t of retirement age (59 ½) and/or meet the requirements for an exception.

These are just the penalties imposed upon you, but in reality, not paying back your 401(k) loan affects your overall finances too. You lose the time value of money. Without the funds in your account, you lose the ability to earn interest/dividends on the funds. You also lose the opportunity to compound those earnings. In essence, you hurt your retirement income by not paying back the loan.

When is a 401(k) Loan a Good Idea?

While most people won’t recommend a 401(k) loan, there are times that it can be a good idea:

  • You can repay the money in less than 12 months
  • You need a down payment for a home in order to lower your interest rate/fees
  • You need the money fast and can’t go through credit inquiries and underwriting
  • You need some repayment flexibility
  • There’s no charge (except interest)

It’s important to realize that while you pay interest on the money you borrow, you pay yourself. You aren’t paying a bank or the plan administrator. The interest goes right into your account. While it likely won’t make up for potential gains you’ll miss out on by taking the money out of your investments, it can be a better way to bridge the gap than a high interest loan. You’ll likely still have a lower 401(k) balance than if you left the money untouched due to the compounded earnings, but the interest is yours nonetheless.

Explore all of your options if you need to borrow money, including borrowing from your 401(k) to see which one makes the most financial sense.