Federal law prohibits you from using your 401(k) as collateral, but that doesn't mean there's no way to get a loan with your 401(k). The Internal Revenue Service permits you to borrow money directly from your account if your 401(k) plan provider permits loans. Those loans must meet certain criteria.
You can borrow up to half your vested account balance or $50,000, whichever is smaller, from your 401(k) plan. But if your 401(k) plan's vest balance is less than $20,000, you can still borrow up to $10,000 if you have at least that much in your account. Your vested account balance refers to the money in your plan that you would get to keep if you left your job. Sometimes, employers make contributions to your 401(k) but require you to give them back if you leave within a few years; those contributions don't count toward boosting your loan limit.
You must repay your 401(k) loan within five years and pay interest on it. Many 401(k) plans simply take money out of your paycheck for repayment. If you're borrowing to buy your primary residence, you can have a longer term on your loan. Though you miss out on the investment gains the money would have earned had you left it in your account, the interest you pay is added back to your balance, so you end up paying yourself back.
If you don't pay back your loan according to the terms, the IRS treats you as taking a permanent distribution of the remaining balance on the loan. That means you're hit with income taxes; borrowers under the age of 59 1/2 also have to pay a 10 percent early withdrawal penalty. For example, if you took out a $20,000 loan and had paid it down to $15,000 before you defaulted, that $15,000 counts as a distribution. It get worse if you leave your job before you finish paying off the loan, because the balance becomes due immediately. If you can't pay, it's an early distribution.
Getting a 401(k) loan is relatively straightforward, because you're essentially borrowing your own money. No credit check or minimum credit score is required, as would be the case if you borrowed money from a traditional bank. If you're married, though, getting a 401(k) plan loan requires a little extra paperwork, because you need your spouse to sign off on it, too.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."