Can I Use My 401(k) as Collateral for a Loan?

Internal Revenue Service (IRS) regulations prohibit using funds in a 401(k) plan account as collateral for a loan, but it is sometimes possible for an individual to obtain a loan directly from their 401(k) account. 

Accessibility of 401(k) Funds

The 401(k) plan has some great features, such as tax-deferred status, matching contributions and catch-up provisions for older savers. That said, one of their drawbacks is lack of accessibility. The structure of a 401(k) account is different from that of a traditional individual retirement account (IRA).

While an IRA is held in the name of the account holder, a 401(k) account is held in the name of an individual's employer on the individual's behalf. The specific 401(k) plan offered through the employer governs the circumstances under which individuals can withdraw money from the account, and many employers only allow early withdrawals in the event of severe financial hardship. This basic structural fact regarding 401(k) accounts is one of the main factors that present obstacles to using account funds as collateral for a loan.

One of the other primary reasons stems from the fact that these accounts are specifically protected from creditors by the Employee Retirement Income Security Act, or ERISA. Therefore, if a 401(k) were used as collateral for a loan, the creditor would have no means of collecting from the account in the event the borrower defaulted on the loan payments.

Borrowing From a 401(k)

In lieu of using a 401(k) account as collateral, an individual may be able to borrow the money they need from the 401(k) account itself. You are only allowed to take a loan from your 401(k) when the initial plan documents that established the employer-sponsored plan explicitly state that a loan provision is included. You can request this information from your company's human resources contact or your 401(k) plan sponsor.

After determining that a loan against your 401(k) is available, make a loan request for the amount you need up to your available limit directly to your 401(k) plan sponsor. For instance, if your 401(k) plan is managed by Fidelity Investments, direct your request there.

Once your plan sponsor processes and approves your 401(k) loan request, you receive a check or direct deposit for the amount requested, minus any loan origination fees.

Borrowing from a 401(k) has both benefits and drawbacks that need to be weighed carefully.

Source: Internal Revenue Service

401(k) Loan Limits

The IRS allows an individual to borrow whichever is less: up to $50,000 or 50% of the account's vested value (the amount in an individual's 401(k) that they would receive in the event they left their job).

While this restriction is the same for nearly all employer-sponsored plans, companies vary on which limitations are placed on the use of loan proceeds. With some 401(k) plans, employees are only allowed to take a loan to pay for medical expenses not covered by insurance or education expenses for a spouse or child. In other cases, they can use loan funds for a down payment on a home purchase or for general financial hardship.

The 50% loan limit may not apply in the event an individual's vested account value is less than $20,000. In that case, the individual may be allowed to borrow as much as $10,000 from the account provided the vested account value is at least $10,000.

Repayment Terms for 401(k) Loans

Just like other loans, funds obtained from a 401(k) account must be paid back, plus interest. Unlike a loan from a bank, the interest paid goes to the 401(k) account itself. With the majority of employers, loan payments cannot be extended past a five-year term and are made through paycheck deferrals. In some cases, such as a loan for a down payment on a home, repayment may be extended past the five-year maximum.

If an individual leaves their job prior to repaying the loan, they have until October of the following year (the due date of your tax return, including extension) to put the money back. If the loan is not repaid within that time frame, it is designated as a premature distribution of funds and is thus subject to income taxes, plus a 10% early withdrawal penalty for borrowers under age 59½.