401(k) Loan Rules – What Plan Participants Need to Know

Many employers allow employees to take loans from their 401(k) account.  A loan feature is generally appreciated by 401(k) plan participants, but the complicated rules that govern these loans are often misunderstood.  This is a problem because taxes or penalties can result when 401(k) participants violate these rules.

We get a lot of questions about loans from 401(k) participants. Below is a FAQ with answers to the most common questions we receive. If you are a 401(k) participant, you can use our FAQ to understand when you can take a loan from your account and how to avoid taxes or penalties.

Under what circumstances can I take a 401(k) loan?

If your 401(k) plan allows loans, you can generally take a loan when the following conditions are met:

• The amount of the loan cannot exceed the lesser of:
  • $50,000, minus your highest outstanding loan balance during the past 12 months, or
  • The greater of $10,000 or ½ of your vested account balance
• The term of the loan cannot exceed five (5) years. Your plan may allow a longer term for loans used to purchase a principal residence
• You must agree to make substantially level repayments – not less frequently than quarterly – over the life of the loan
• The loan must be subject to a legally-enforceable agreement.

What are the pros and cons of taking a 401(k) loan?

Pros:

• Convenience – Requesting a loan is usually a straightforward process with little to no documentation required. Repayments are usually made automatically by payroll deduction.
• Interest – The interest earned on your loan is paid to your 401(k) account, not a bank. The interest rate is generally lower than what you would pay elsewhere - usually prime + 1 to 2%.
• Repayment flexibility – You define the repayment period of your loan.

Cons:

• Lost earnings – While your 401(k) account earns loan interest, the amount is often less than the earnings you would have received on the investments sold to take the loan. These lost earnings can materially reduce the amount of your nest egg at retirement.
• Repayment upon termination – Most 401(k) plans require the full repayment of an outstanding loan balance upon termination of employment.

Can I default on my 401(k) loan while employed?

Generally, no. 401(k) loans must be subject to a legally-enforceable agreement to not be considered a taxable distribution.  This agreement obligates you to repay your loan based on a defined payment schedule – almost always by payroll deduction.  Your employer must enforce this agreement while you are employed or risk 401(k) plan disqualification.

What happens to my 401(k) loan if I terminate employment?

Most 401(k) plans require the full repayment of an outstanding loan balance upon termination of employment.  If you fail to do so, your outstanding loan balance will be “offset” – basically, become a taxable distribution.  Generally, loan offsets occur the earlier of:

• The date you take a full distribution of your account
• The last day of the calendar quarter following the calendar quarter in which you missed your first loan repayment.

You may be able to roll your loan to a new employer’s 401(k) plan to avoid an offset.  Many 401(k) plans won’t accept a direct rollover of participant loans, but this option is a possibility.

What are the tax consequences of a 401(k) loan offset?

For the most part, the offset of an outstanding loan balance is treated like a cash distribution for Federal income tax purposes. It’s taxable at ordinary income rates and subject to a 10% premature distribution penalty if the employee is under age 55. 

The key difference? There is no 20% mandatory tax withholding unless the offset occurs simultaneously with a cash distribution.

Examples:

• $20,000 loan offset + $0 cash distribution – $0 tax withholding
• $20,000 loan offset + $30,000 cash distribution – $10,000 tax withholding ($50,000*20%)

Can the dollar amount of a 401(k) loan offset be rolled to an IRA?

Yes, you can roll the cash equivalent of a loan offset to an IRA.  To do so, you would write a personal check in the amount of the loan offset to your IRA.  The deadline for making this rollover is 60 days following the date of the offset.

Where can I go to learn my 401(k) plan’s loan options?

Your 401(k) plan’s Summary Plan Description (SPD).

Know your options!

401(k) loans are popular because they’re often a ticket to fast cash.  However, they’re also subject to strict rules that can result in painful taxes or penalties when violated. You want to understand these rules to avoid trouble - particularly if you think you might have a hard time repaying the loan while employed or considering a job change.