Taking a 401(k) Loan? Here’s What to Know

Many 401(k) plans allow users to borrow against their retirement savings. It’s a relatively low-interest loan option that can help cover a large expense, but tread lightly. Getting a 401(k) loan can mean long-term retirement losses or penalties if you’re unable to repay the loan.

What is a 401(k) loan?

Employer rules vary, but 401(k) plans typically allow users to borrow up to half of their vested retirement account balance or $50,000 — whichever is less — for a maximum of five years ^[0]

After other borrowing options are ruled out, a 401(k) loan might be an acceptable choice for paying off high-interest debt or covering a necessary expense. But you’ll need a disciplined financial plan to repay it on time and avoid penalties.

Other retirement plans, such as a 403(b)s, offered to public school and church employees, or 457(b)s, offered to employees of state and local governments, provide loans against retirement savings, but borrowing guidelines may vary by employer.

Benefits of a 401(k) loan

1. Low interest rates

Unlike many other forms of credit, 401(k) loans usually have single-digit interest rates. Interest typically equals the prime rate plus one or two percentage points. By comparison, credit card annual percentage rates can be as high as 30%.

2. Interest paid goes back to you

While interest rates on most loans are paid to the lender, the interest on 401(k) loans goes back into your retirement account, which may help offset lost growth potential.

3. No credit check

Personal loans and other lines of credit often require strong credit and income to qualify or get a low rate. There’s no credit check with 401(k) loans, so a low score isn’t a barrier to borrowing.

Drawbacks of a 401(k) loan

1. Cuts into your retirement savings 

When you take money out of your retirement account, you miss out on both stock market gains and the magic of compound interest. Although your loan payments are reinvested into your 401(k) account, the cost to purchase shares in your selected investments may increase — resulting in the decrease of the buying power, as well as compound interest potential, of these newer purchases.

Moreover, you may reduce your 401(k) contributions while making loan payments, setting back your retirement savings further.

2. Job loss means faster repayment

As any 401(k) loan is an agreement made with your employer, if you leave your job while repaying your 401(k) loan, the balance may come due quickly.

Federal rules require the outstanding balance be paid by your tax return’s due date for the tax year you left your employer. For example, if you left your job in January 2024, you’d have to repay the loan in full by the April 2025 tax return deadline.

3. Potential tax penalties for nonpayment

If you’re unable to repay the loan, the IRS will consider the unpaid amount a distribution and count it as income when you file that year’s taxes. You’ll also incur a 10% early withdrawal penalty if you’re under the age of 59½.

What are the rules for a 401(k) loan?

With a 401(k) loan, you are limited to withdrawing either 50% of your vested account balance or $50,000, whichever is less. One important caveat: If you have less than $10,000 vested in your 401(k) account, you may be able to borrow the full available balance, according to IRS rules ^[0]

Your plan may also set a maximum number of outstanding loans or require the signed permission of your spouse or partner if the loan is greater than $5,000.

What is the 12-month rule for 401(k) loans?

You may be able to take out several 401(k) loans at once, depending on your plan. However, during any 12-month period, the total outstanding balance can't exceed the limits of 50% of your vested account balance, or $50,000, whichever is less.

401(k) loans to purchase a home

Most 401(k) loans have a maximum repayment period of five years. However, there is one important exception to that rule. If you are using the loan toward the purchase of a primary residence, the term may be extended up to 10 years or more.

Consult with your plan administrator to determine the length of repayment limits with the purchase of a home.

401(k) loan vs. 401(k) withdrawal: What’s the difference?

With a 401(k) loan, you don’t have to pay taxes and penalties when you borrow from your account, as long as you make regular payments and repay on schedule. The loan amount and interest paid are put back into your 401(k) account and typically reinvested based on your current investment fund selections.

A nonqualified 401(k) withdrawal is penalized in two ways: If you withdraw the money before age 59½, you must pay an immediate 10% tax penalty. Also, cash received will be taxed as ordinary income for the year. Certain expenses — such as medical bills, tuition, cash to avoid eviction or foreclosure — may qualify as a hardship withdrawal, and are not subject to the 10% tax penalty.

Unlike 401(k) loans, you are not required to pay the cash back on a hardship withdrawal, but if you take one, you may be prohibited from making any contributions to your account for six months.

Should you use a 401(k) loan to pay off debt?

Before you get a 401(k) loan to pay off debt, consider other options that won’t impact your retirement savings.

Debt consolidation: Debt consolidation allows you to roll multiple high-interest debts to a balance-transfer card or personal loan with a lower interest rate. You then have a single monthly debt payment and less total interest cost.

» MORE:  Best Installment Loans

Debt relief options: If you can’t pay off unsecured debts — credit cards, personal loans and medical bills — within five years, or if your total debt equals more than half your income, you might have too much debt to consolidate. Your best option is to consult an attorney or credit counselor about debt relief options, including credit counseling.

Bankruptcy: Chapter 13 bankruptcy and debt management plans require five years of payments at most. After that, your remaining consumer debt is wiped out. Chapter 7 bankruptcy discharges consumer debt immediately ^[0]

Unlike consumer debt, a 401(k) loan isn’t forgiven in bankruptcy.

» MORE: Tools and tips for paying off debt

401(k) loan alternatives

Because of the risks associated with 401(k) loans, first consider alternative financing options.

Alternatives for large expenses

Personal loans: You can use a personal loan for almost anything, including debt consolidation, home repairs, emergencies and medical bills. Loan amounts are from $1,000 to $100,000, and rates are 6% to 36%. They’re usually repaid in monthly installments over a term from two to seven years.

These loans are unsecured, so there’s no collateral required. A lender uses financial and credit information to determine whether you qualify and your loan’s annual percentage rate.

Home equity loans and lines of credit: A home equity loan or line of credit is a low-interest way to cover urgent home repairs or other emergencies. Depending on which you choose, you can typically borrow up to 85% of the home’s value, minus what you owe on the mortgage. Rates are often in the single-digits, and repayment terms are from five to 30 years.

Both home equity loans and lines of credit require you to use your home as collateral for the loan, meaning the lender can take it if you fail to repay. The biggest difference between these financing options is their borrow-and-repay structures.

» MORE: Home equity loan vs. HELOC

0% APR balance transfer credit card: Another option is to move high-interest debt to a balance transfer card with a zero-interest promotional period. You usually need good or excellent credit to qualify (690 or higher credit score), and the amount you can transfer depends on the credit limit the card issuer gives you. If you qualify, you must pay the balance during the interest-free promotional period — usually six to 12 months — to avoid paying the card’s (often high) regular APR.

» MORE: Should you get a balance transfer card?

Alternatives for small expenses

Family loans: It’s worth asking a trusted friend or family member for a loan to help bridge an income gap or cover an emergency. There’s no credit check with this option and you can draw up a contract with the lender outlining interest and how the loan will be repaid.

Cash advance apps: Cash advance apps let users borrow up to a few hundred dollars and repay it on their next payday. These advances can be a fast way to cover a small, urgent expense. There’s no interest, but the apps often tack on fees for fast funding and ask for optional tips.

Buy now, pay later: If you’re repairing a car, replacing a laptop or buying a new mattress, the merchant may offer buy now, pay later plans. This payment plan lets you split up a purchase into smaller, usually biweekly payments. Having bad credit (a score lower than 630) may not prevent you from qualifying because there’s usually only a soft credit check.