401(k) loans: how they work and what they cost

Many 401(k) plans let participants borrow from their own accounts. The money comes out of the participant's balance, is repaid with interest through payroll deductions, and goes back into the same account. Done according to the rules, a loan is not a taxable event. Done wrong, or interrupted by a job change, it can become one.

Whether a plan offers loans at all

Loans are optional for employers. The IRS notes that a plan sponsor is not required to include loan provisions, and that the Summary Plan Description is the place to find out whether a plan has them. Plans that do offer loans set their own terms within the legal limits, including a minimum loan amount, how many loans can be outstanding at once, the interest rate and any fees.

IRAs are different. The IRS states that IRAs and IRA-based plans such as SEP and SIMPLE IRAs cannot offer loans. This is one of the practical differences between keeping money in an employer plan and rolling it to an IRA.

How much can be borrowed

The law sets a ceiling. According to the IRS, the maximum a participant may borrow is 50% of the vested account balance or $50,000, whichever is less. The IRS gives two examples:

• A participant with a vested balance of $80,000 may borrow up to $40,000.
• A participant with a vested balance of $120,000 may borrow up to $50,000, because half the balance ($60,000) is above the dollar cap.

There is an exception for small accounts: if 50% of the vested balance is less than $10,000, the participant may borrow up to $10,000. Plans are not required to include this exception.

Note that the limit is based on the vested balance. Employer contributions that have not yet vested do not count. See vesting schedules.

For someone who has had another loan within the past 12 months, the $50,000 cap is reduced by a formula tied to the highest outstanding balance during that period. The IRS loan FAQs walk through the calculation.

Repayment rules

The IRS summarizes the repayment requirements this way: generally, the employee must repay a plan loan within five years and must make payments at least quarterly. Payments must be substantially equal and include both principal and interest. In practice, most plans collect payments through payroll deduction.

The main exception to the five-year limit is a loan used to purchase a primary residence, which may be repaid over a longer period.

The interest does not go to a bank. It is paid into the borrower's own account along with the principal. That feature is sometimes described as "paying yourself interest," which is accurate but incomplete, as the cost section below explains.

What happens if the loan is not repaid

A loan that goes into default is generally treated as a taxable distribution of the entire outstanding balance. The IRS calls this a "deemed distribution." The amount is included in income for the year, and it may also be subject to the 10% additional tax on early distributions if the borrower is under age 59½ and no exception applies. Those exceptions are covered in early withdrawals and the rule of 55.

A deemed distribution cannot be rolled over to another retirement account, according to the IRS loan FAQs.

Leaving the job with a loan outstanding

This is where many loan problems arise. The IRS explains that plan sponsors may require an employee to repay the full outstanding balance when employment ends. If the employee cannot, the plan typically reduces the account balance by the unpaid amount. This is called a "plan loan offset," and it is treated as an actual distribution.

Unlike a deemed distribution, a loan offset can generally be rolled over. When the offset happens because of plan termination or severance from employment, the IRS loan FAQs and IRS Topic no. 413 say the person has until the due date of their tax return, including extensions, for the year the offset occurs to complete the rollover. Doing so means depositing an amount equal to the offset, from other funds, into an IRA or another eligible plan.

Here is a hypothetical example. Someone leaves a job with a $50,000 vested balance and a $10,000 loan outstanding. The plan offsets the loan, leaving $40,000, which the person rolls directly to an IRA. The $10,000 offset is taxable income for the year unless the person contributes $10,000 from savings to the IRA by the tax-return deadline.

The real costs of a plan loan

Because the interest goes back into the account, a plan loan can look free. It is not. The costs are less visible than a bank's interest charge.

• Time out of the investments. Borrowed money is no longer invested in the plan's funds. While the loan is outstanding, that portion of the account earns only the loan interest the borrower pays in. Whether that turns out better or worse than staying invested depends on what the investments do during that period, which cannot be known in advance.
• Fees. Many plans charge a loan origination fee and sometimes an ongoing maintenance fee.
• After-tax repayment. Loan payments come out of take-home pay. They are not new contributions and do not reduce taxable income.
• Reduced contributions. Some borrowers cut back on regular contributions to afford the loan payment, which can also mean missing part of an employer match.
• Job-change risk. As described above, losing or leaving a job can turn the unpaid balance into taxable income on short notice.

Questions worth asking before borrowing

• What fees does the plan charge for a loan?
• What interest rate applies, and how is it set?
• Can contributions continue while the loan is being repaid?
• What happens to the loan if employment ends, and can payments continue afterward?
• What other sources of funds are available, and what would each one cost?