401(k) Loans: How They Work, What They Really Cost, and the Job-Loss Risk
Borrowing from your 401(k) means paying interest to yourself, which sounds free. The real costs are lost growth, after-tax repayment, and what happens if you leave your job. Here is how the rules work.
Many 401(k) and similar plans let you borrow from your own account. You repay yourself with interest through payroll deductions. It can be cheaper and easier than other loans. It also carries risks that aren't obvious at first.
The basic rules
Under federal rules, plans that offer loans generally limit them to:
- the lesser of $50,000 or 50% of your vested balance, with an exception allowing up to $10,000 when half the vested balance is less than that, if the plan permits;
- repayment within five years, with payments at least quarterly; loans to buy a primary residence can have longer terms;
- the plan's own rules, which can be stricter.
What it really costs
Lost growth. Money borrowed isn't invested. If markets rise while it's out, you miss those gains. The interest you pay yourself may be less than what the money would have earned.
After-tax repayment. You repay a traditional 401(k) loan with after-tax paycheck dollars, and later the money is taxed again when withdrawn in retirement. The interest portion is effectively taxed twice.
Reduced contributions. Some people lower their regular contributions while repaying, which can mean missing employer match; see 401(k) basics.
The job-loss risk
If you leave your job, the plan may require the loan to be repaid. If it isn't, the unpaid balance is generally treated as a distribution. You can avoid immediate tax by rolling over an amount equal to the unpaid balance to an IRA or another plan by your tax return due date, including extensions, for the year the loan was offset. If you can't, it's taxable, and possibly subject to the 10% additional tax if you're under 59½.
A hypothetical example: a $15,000 unpaid balance at a 22% bracket, under 59½:
Show the numbers behind this chart
| Amount | |
|---|---|
| Income tax | $3,300 |
| 10% additional tax | $1,500 |
When a 401(k) loan can make sense
- A short-term need with very secure employment and a clear repayment plan.
- Replacing high-interest debt, if you won't run the debt back up.
- When the alternatives are much more expensive or would require an early withdrawal.
When it's risky
- Your job isn't secure.
- You'd need to reduce retirement contributions to repay.
- You'd use it for ongoing spending rather than a one-time need.
The takeaway
A 401(k) loan pays interest to yourself, but it isn't free: lost growth, after-tax repayment, and the risk of a taxable distribution if you leave your job all matter. Read your plan's loan rules and have a repayment plan that survives a job change.
Sources
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