Overview: Many 401(k) plans include a loan feature. If a plan does include a loan feature, loans must be available to all plan participants. While the federal government does not place restrictions on how loan proceeds can be used, an employer has the option to limit circumstances under which a loan can be taken.
Employers, in conjunction with the plan administrator, determine how much can be borrowed from the 401(k). A common design is to have a minimum loan amount of $1,000 and a maximum loan amount of up to 50 percent of the vested balance. Loans must be paid back over a period of five years. This timeframe may be extended if the loan is used to purchase a home. Loans to married participants require spousal consent.
A benefit to employees is that they are paying the interest on the loan to themselves (usually at a low interest rate) and pay no taxes on the interest until the money comes out of the plan at retirement. A significant disadvantage is if an employee terminates employment, the loan must be paid in full within a short period of time (usually 60 days). Failure to do so could result in substantial fees and penalties.
Author: Tracy Morley, SPHR, Legal Editor
Employment glossary definition of 401(k).
HR guidance on the risks and benefits of offering 401(k) loans to employees.