If you need money and have a 401k, you have two main choices inside the plan: borrow from it or withdraw from it. They are very different in cost and risk.
The short version
| Loan | Early withdrawal | |
|---|---|---|
| Taxed? | No, if you repay on time | Yes, as income |
| 10% penalty? | No | Yes, unless an exception applies (before 59½) |
| Do you pay it back? | Yes, with interest, to your own account | No |
| Effect on your balance | Reduced until repaid | Reduced for good |
| Main risk | Unpaid balance becomes a taxable withdrawal | Lost tax, penalty and growth |
How a 401k loan works
Your plan decides whether loans are allowed. If they are, the IRS rules say:
- You can borrow up to the greater of $10,000 or 50% of your vested balance, but not more than $50,000, whichever is less. The $50,000 can be reduced if you already have other loans.
- You must repay within 5 years in substantially equal payments, made at least every quarter. Payments usually come out of your paycheck.
- If you use the loan to buy your main home, the repayment time can be longer than 5 years.
- The interest rate is set by your plan, often a point or so above a base rate. The interest goes back into your account.
What a loan really costs
It is tempting to say a loan is free because you pay the interest to yourself. It is not quite free:
- Missed growth. The money you borrow is out of the market while you repay. If the market grows more than your loan interest, you lose that difference.
- The interest is paid with after-tax money. You repay from take-home pay, which has already been taxed. The interest part of each payment goes into your account and is taxed again when you take it out in retirement.
- Fees. Some plans charge setup or yearly fees.
Our loan calculator shows your payment, the interest and how your account could end up with and without the loan.
The biggest risk: leaving your job
If you leave or lose your job, many plans require you to repay the loan quickly, often within weeks. If you cannot, the unpaid balance is treated as a deemed distribution, a taxable withdrawal, and the 10% penalty may apply if you are under 59½.
There is some relief: if your plan simply reduces your balance by the unpaid loan, that "offset" can be rolled over to an IRA or another plan. You have until your tax return due date, including extensions, for the year of the offset to do it.
When a loan can make sense
- You need a modest amount for a short time.
- Your job is stable.
- You have compared it with other ways to borrow.
- You will keep contributing to the plan while you repay, so you do not lose your match.
When to be careful
- You may change jobs soon.
- The amount is large relative to your balance.
- You would stop saving to afford the payments.
Loan or withdrawal?
If you can repay it on time, a loan usually costs far less than a withdrawal, because there is no tax and no penalty. If you cannot repay, a loan can turn into the worst of both. Compare both in our early withdrawal calculator and loan calculator, and read the early withdrawal rules for the exceptions that may apply.
401k loan calculator See your payment and how a loan could affect your account.Sources
This article is for education and is not financial, tax or legal advice. Figures are checked against the sources above and may change. Read the full disclaimer.