What is a 401(k) Loan and How Does it Work?

About 60 million Americans have an active 401(k) account. For many, a 401(k) is the primary method used to save for retirement (although there are some 401(k) alternatives).  

Saving for retirement is vital. But, sometimes, more immediate financial needs pop up. 

When this happens, you may be tempted to withdraw from your 401(k), but this can come with tax penalties. Or, you may be tempted to use a credit card or personal loan, but these options can cost a fortune in interest. 

Luckily, there’s an alternative: You may be able to borrow a loan from your  401(k) and pay it off over time. 

This approach can have some benefits, but it’s important to understand all the angles. How does a 401(k) loan work, exactly? 

How does a 401(k) loan work?

401(k) loans are quite different from traditional loans. 

When you take out a 401(k) loan, you are essentially taking out a loan from your own account. 

Because you’re both the lender and the borrower, there isn’t a lengthy loan application process. There’s also no impact on your credit score. 

On top of all that, the interest you pay goes into your 401(k) — so you’re just paying interest to your future self. 

How do I borrow from my 401(k), exactly? Here’s how it works:

• You sell assets in your 401(k) until you have an adequate cash balance

• You can borrow up to the 401(k) loan limit (see below), with an absolute maximum of $50,000

• You agree to repay the loan over time, with a maximum time frame of 5 years

• You make regular repayments (at least once per quarter) back into your 401(k)

• You pay interest, but the interest goes into your own 401(k) account

• Loan repayments may be deducted from your paycheck, or taken out of your bank account

Keep in mind that not all 401(k) plan providers offer the ability to take a 401(k) loan. Check with your workplace Human Resources department for details on how to get a 401(k) loan. 

What’s the downside?

Before going further, it’s important to understand a significant drawback of a 401(k) loan: You will miss out on any stock market gains during the time you have the loan out. 

For example, let’s say you take out a $50,000 loan. To do that, you’ll need to sell $50,000 worth of assets in your 401(k). If the stock market goes up by the time you repay the loan, you’ll miss out on the growth that you would have had without taking out the loan. 

Loan amounts

401(k) loans can be issued for whichever amount is lower between these figures:

• Up to $50,000

• The greater of $10,000, or 50% of your account balance

For example:

• If you have $100,000 (or more) in your 401(k), you can borrow a full $50,000 from the account. You can’t borrow more than $50,000, even if you have $1 million in your 401(k) 

• If you have $40,000, you can borrow up to $20,000 (50% of your balance)

• If you have $12,000, you can borrow up to $10,000 (because $10,000 is greater than 50% of your balance)

Some loans have a minimum amount you can borrow, as well. This depends on the plan details, which are specific to each 401(k) provider.

Fees and tax implications

How does a 401(k) loan work in terms of taxes? 

Taking a 401(k) loan isn’t a taxable event, so you won’t need to pay income tax. There’s also no early withdrawal penalty, because you technically aren’t withdrawing the funds. 

However, if you fail to make repayments on the loan, the loan will enter default. In this situation, the loan is typically treated as a taxable distribution, or a “deemed distribution.” 

Once this happens, you may have to pay income taxes on the loan as if it had been an early withdrawal. You’ll also likely face early withdrawal penalties, unless you’re of retirement age (59 ½). 

The details of how a loan default will work will be spelled out in the 401(k) plan agreement. However, suffice it to say, you’ll want to do everything in your power to avoid defaulting on a 401(k) loan. 

As for fees, 401(k) loans do charge interest. Interest rates on 401(k) loans are usually 1-2% higher than the current prime rate. So, if the prime rate is 3.25%, the 401(k) loan interest rate could be around 4.25% to 5.25%. All interest paid goes into your own 401(k), so interest isn’t a major concern. 

401(k) plan providers may charge a fee to issue a loan, often ranging from $50 to $100. Check the details of your plan to learn more. 

How are 401(k) loans paid back?

401(k) loans are paid back in regular installments. Some plans require monthly payments, while others allow quarterly (every 3 months). 

Certain plans require loan repayments to be taken out of paychecks, similar to standard 401(k) contributions. Other plans allow direct payments from your bank account. 

All repayments — including interest — go back into your 401(k). Depending on your plan’s settings, they may be automatically invested, or you may need to manually purchase new investments. 

Check plan details to be sure of your repayment plan. 

Do 401(k) loans affect credit score?

401(k) loans have no impact on your credit score. Since you’re both the lender and the borrower, nothing is reported to the three main credit bureaus. 

Pros and cons of a 401(k) loan

There are both advantages and disadvantages to consider when it comes to 401(k) loans: 

Advantages

• Speed: 401(k) loans can be issued quicker than traditional loans from a bank. 

• Lower costs: The costs associated with a 401(k) loan are often lower than something like a personal loan.

• Interest is paid to yourself: You’ll pay interest on a 401(k) loan, but that interest goes into your own retirement account. Instead of paying a lender, you’re paying yourself interest. 

• No impact on credit: 401(k) loans don’t impact your credit score, because there’s no lender involved (you are your own lender). 

Disadvantages

• Missed investment growth: Perhaps the biggest downside is that you may miss out on potential investment growth during the time you have the loan out. On average, the stock market goes up around 10% per year (although this varies dramatically from year to year). If you pull funds out of your 401(k) via a loan, you’ll miss out on that growth.

• Not available on all 401(k) plans: Some 401(k) providers don’t give the option to take out a loan from your 401(k) balance. If your plan doesn’t support loans, you’ll need to seek out another option.

• No credit building: A 401(k) loan doesn’t involve a lender that reports payments to the credit bureaus. This means the loan will not affect your payment history, or help to strengthen your credit score. 

Alternatives to 401(k) loans

If a 401(k) loan is not available to you, or you don’t want to sidetrack your retirement savings, here are some alternatives to consider.

Savings 

Dipping into your emergency fund, or any other savings you have, is one option. Even if it means sidelining your other financial goals temporarily, utilizing existing savings first might make financial sense. 

Home equity line of credit (HELOC) 

If you own your home, getting a home equity line of credit (HELOC) may be an attractive option. A HELOC is a form of revolving credit, somewhat like a credit card. This means you’ll be approved for up to a certain amount, and you can spend as needed — up to the credit limit — using the line of credit.

Personal loan

A personal loan is an installment loan for a set amount that’s paid back in monthly installments. They are typically cheaper than credit cards, but can still be costly. 

Home equity loan

A home equity loan, or a reverse mortgage, lets you take out an installment loan using your home equity as collateral. They tend to offer lower interest rates than many alternatives, but if you default on the loan, you risk losing your home. 

It’s wise to avoid any high-interest loans, like payday loans or credit cards. If you have access to a 401(k) loan, it will be a far better option than using your credit card. 

If you have existing credit card debt you’d like to pay off, you can check out Tally†. Tally helps qualifying Americans consolidate their credit card debt, so they can possibly pay it off faster.

Check your 401(k) plan for details

This guide explains how the typical 401(k) loan works. However, the details will vary depending on what company manages your 401(k) and the specific agreement they have in place with your employer. 

Some plans require monthly payments, while others require quarterly payments. Interest rates vary between plans. And some plans don’t allow loans at all. 

If your 401(k) plan is offered through your employer (many are), check with your company’s Human Resources department for details. 

†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. Based on your credit history, the APR (which is the same as your interest rate) will be between 7.90% - 29.99% per year. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 - $300.