If you have an established 401(k) and need to access your money, you can use a 401(k) loan to maintain your tax advantages. These loans can provide lower interest rates than you may find on other types of loans like personal loans.
Like with any loan, you must repay a 401(k) loan over a set period of time and according to the loan terms. Learn more about how repayment works.
Key Takeaways
- A 401(k) loan can provide competitive interest rates and you can maintain your tax advantages.
- Repayments are set according to your loan term, but you can repay a 401(k) loan early.
- If you change jobs, you may have to pay back the loan earlier.
- You can borrow up to $50,000 or half the amount in your 401(k), whichever is less.
What Is a 401(k) Loan?
A 401(k) loan is a loan in which you borrow money from your employer-sponsored retirement plan and you maintain tax benefits when you repay the loan. A 401(k) is a defined-benefit retirement plan offered through your employer, allowing you to contribute funds to a plan each paycheck. With a traditional 401(k), contributions are made pre-taxes, lowering taxable income. Some plans have added Roth IRA versions as well in which contributions are taxed, but withdrawals in your retirement years are not.
A 401(k) is often a significant portion of most employees’ retirement plan. Many employers match employee contributions as an additional benefit. In total, you can contribute up to $20,500 in 2022, or $27,000 if you’re 50 or over.
By borrowing from that 401(k), employees have an easy way to get a loan without a credit check or expensive closing costs. Most employees can apply for a 401(k) loan online from their plan administrator, and money will be deposited directly into their checking account within a few days of approval. 401(k) loans accrue interest, which is typically a few points above the prime interest rate. But that interest is paid back into your account, so you don’t lose it to a lender.
If you’re in the armed forces, you may have a longer repayment period. Your employer may suspend repayments while you’re on active duty and then extend your repayment window by the same amount of time.
Paying Back a 401(k) Loan
You can quickly get your payout from a 401(k) loan, and then you typically have up to five years to repay your loan. If you’re using the loan to pay for a house, you may have longer than five years to repay it. The IRS stipulates that payments must be made at least quarterly, although many set up monthly or bi-monthly payment plans.
When you apply for your loan, you’ll also have to agree to terms of repayment. Most employees set up automatic payroll deductions to repay their loans and pause contributions until the loan is repaid.
Automatic payroll withdrawals make it easy to stay on target for your loan repayment, but you may be motivated to pay off your loan earlier and return to active investing. There are no prepayment penalties with a 401(k) loan, so you can pay more than your agreed-upon rate to pay off the loan early. Or you can make a lump-sum payment to satisfy the loan early.
If you lose or leave your job, you may have to pay back the loan sooner than the loan term. Your loan documents should establish a grace period for how long you have to repay the loan if you are no longer receiving a paycheck from your employer.
If you can’t pay your loan back within the stated amount of time, the loan may be considered a withdrawal from your 401(k) and so it could be subject to early withdrawal penalties and income tax.
How Much Can I Borrow From My 401(k)?
Investors may borrow up to $50,000 or half of the amount vested in the plan, whichever is less. Some plans may also have a minimum amount that you must borrow. Check with your benefits manager to determine your limits.
Can I Borrow From a Solo 401(k)?
If you’re self-employed and use a solo 401(k) as a retirement vehicle, you can borrow from it, following the same rules as a traditional 401(k). SEP IRAs and SIMPLE IRA plans are not eligible for loans.
Can I Repay My Loan Using Pretax Dollars?
One major benefit of contributing to a 401(k) is that it can lower your taxable income because the contributions are made with pre-tax dollars. However, repayments on a 401(k) loan are made with after-tax dollars.
The Bottom Line
When you need cash, a 401(k) loan can offer a quick and flexible solution with competitive rates. In fact, the interest you’re paying ultimately goes to you. Before taking out a 401(k) loan, work with your benefits manager to establish a plan that works for your budget. And if you change jobs, have a plan to pay the loan back quickly, or you’ll risk additional tax penalties.