If you need money to cover an expense, borrowing from your 401(k) may be an option. Your 401(k) contributions can be used before retirement, with some conditions, if you prefer not to get a traditional loan or don’t qualify for one.
However, a 401(k) loan comes with very specific terms, so it may not be the best option for you — especially if you don’t want to limit your retirement balance growth.
When you use a 401(k) loan, you borrow money from your 401(k) plan. This money must be paid back with interest according to the loan terms.
You can request a loan from the company that manages your 401(k). You typically must repay the loan within five years, and you’re required to make loan payments at least quarterly. Keep in mind that these payments aren’t considered plan contributions. If you fail to repay the loan on time, including interest, it becomes a plan distribution, and you must pay income taxes on it.
| Good to know: You may have to pay an extra 10% tax on the distribution amount if you’re under the age of 59 ½ and don’t qualify for another exception. |
You can borrow the greater of $10,000 or 50% of your vested account balance, or you can borrow up to $50,000 — whichever is less. This means if you have $50,000 vested in your 401(k), you can borrow up to $25,000. But if you have $140,000, you can’t take out half ($70,000). Instead, you can take up to $50,000.
You can take out more than one loan from your 401(k) at a time, but your total loan balance can’t exceed the maximum borrowing amount. Not all 401(k) plans allow you to take out loans, so it’s important to confirm that a 401(k) loan is an option under your plan.
Unlike other types of loans, there aren’t many eligibility requirements for 401(k) loans. Typically, your plan must offer a loan option, and you must have a vested balance. Your vested account balance is the money you actually have ownership of. Some employers that provide retirement matching benefits require you to stay with the company for a few years for your funds to become fully vested.
In addition, you may need written approval from your spouse if you’re married.
A 401(k) loan has pros and cons, and it’s important to understand both.
A 401(k) loan is generally an option of last resort since tapping your retirement money early can have significant consequences during your retirement years. Plus, most retirement funds are protected if you file bankruptcy.
But choosing a 401(k) loan may make sense if you need to pay off debilitating credit card debt. You could potentially save a lot of money on interest by paying off your debt this way.
On the flip side, determine whether you can meet all the loan terms for this option to avoid costly penalties. A 401(k) loan is not a good option for entertainment costs like a vacation or lavish gifts.
Depending on your plan, you may be required to pay back your 401(k) loan balance in full if you leave your job. You have until the federal income tax filing deadline (including extensions) for the tax year when you leave your job to fully repay it. However, if you leave your job to perform military service, your loan payment requirements may be suspended.
If you leave your job and can’t repay the loan, your employer will report it as a distribution to the IRS. But you may be able to avoid tax and penalties if you roll over part or all of your loan’s outstanding balance to an IRA or other eligible retirement plan before the annual federal tax deadline.
You have other options if you feel that a 401(k) loan isn’t right for you. Some of these alternatives include: