401(k) Loan Rules: How Does Borrowing From 401(k) Plans Work?

Although the aim of 401(k) plans is to build income for retirement, some people find another use for their savings by taking out loans against them. If a plan allows borrowing, this may seem a relatively easy way to access a quick loan during your working life. What are the 401(k) loan rules and how does borrowing from a plan work?

401(k) Loan Rules, Tax and Borrowing Limits

A loan from a 401(k) plan is not subject to tax if it meets criteria set by the IRS. You can borrow up to 50% of the vested balance up to a maximum limit of $50,000. Borrowing must be paid off within 5 years, although this period may be extended if the money is used to buy a main residence for the first time. Repayments have to be made at least once a quarter and must be made in more or less level amounts.

Do All 401(k) Plans Allow Loans?

Although all 401(k) plans can allow loans, not all of them do. The rules set on borrowing may also vary from plan to plan which could see additional criteria added to standard IRS guidelines. So, for example, one employer may offer loans for any purpose; another may rule that loans can only be used for specific purposes (i.e. for medical costs, college expenses or to buy a first home). Those considering 401(k) loans should, therefore, check if they are offered by plans and if there are any additional specifications to consider.

How Does Borrowing From a 401(k) Plan Work?

Each plan will outline the application process for a loan. This may involve completing a form or applying by phone. It does not involve a credit check. Loans from 401(k)s must be repaid with interest as outlined by the plan. Repayments can be deducted from pay checks or paid from bank accounts but will not be made with pre-tax dollars as with plan contributions. If you don’t pay off your borrowing to schedule, then the borrowing may be viewed as an early withdrawal, at which point you may be liable to income tax and a 10% penalty. If you change job or are laid off, the loan may become due more quickly.

Are 401(k) Loans a Good Idea?

There are advantages and disadvantages to borrowing against a 401(k) plan and it may be wise to think hard about the pros and cons before applying for a loan. Although this can seem to be an easy and cost-effective way to borrow, it may have an impact on retirement income in the future. In some cases, if loans are not an option, then a hardship withdrawal may also be worth considering.