Can you refinance a 401k loan?

If you need urgent cash for a short-term need such as medical expenses and college fees, borrowing from your 401(k) is one of the most convenient options. A 401(k) plan allows participants to borrow against their retirement savings, and pay back the loan with interest. If you are paying too much in loan interest or you want to extend the repayment period, you could be wondering if you can refinance the 401(k) loan.

Yes, you can refinance an existing 401(k) loan by taking a second 401(k) loan to pay the outstanding balance of the original loan. Usually, you can borrow up to 50% of your vested 401(k) balance, or a maximum of $50,000. If your outstanding 401(k) loan balance does not exceed 25% of your vested balance, you can take a second 401(k) loan if the plan approves the transaction. By refinancing, you can negotiate more flexible loan terms.

How to Refinance 401(k) Loan

If you decide to refinance a 401(k) loan, you have the following two options:

Refinance with 401(k) funds

Although it is possible to refinance a loan, not all employers authorize it. You must first check with your employer to know if it allows 401(k) loan refinancing. If they do not allow it, you can take a separate 401(k) loan if you have not maxed out your loan limit. For example, if you have a 401(k) balance of $100,000, it means you can borrow up to $50,000. If you have an existing $20,000 401(k) loan, you can take up to an additional $30,000 loan in the second loan.

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Borrow from another source

If you have maxed out your 401(k) loan limit and you cannot be approved for a second 401(k) loan, you can borrow from another source. The most common option is to take a home-equity loan using your home as collateral, and using the loan proceeds to pay off the 401(k) loan. If you are in the good to excellent credit score range, you may get a personal loan or credit card loan at favorable terms. The external loan would make sense if it saves you money in interest costs, and gets a longer loan repayment period.

Authorization to Refinance 401(k)

Most 401(k) plans require participants to seek authorization when taking a second 401(k) loan. Employers must protect the 401(k) from unilateral withdrawals, which could put the plan at risk of losing its tax-favored status. Hence, some employers may reject a second 401(k) loan if you have an outstanding 401(k) loan balance. Before refinancing your 401(k) loan, you should check the plan documents or consult the plan administrator to know the 401(k) plan procedures regarding a second 401(k) loan.

Benefits of refinancing 401(k) loan

If your employer approves your request for a second loan, you may be able to refinance your existing loan. You can use the second loan to pay off the outstanding balance of the existing 401(k) loan, and use the remaining funds to finance your project. This eliminates the need to take out multiple loans to finance specific needs or provide proof of hardship when making an early 401(k) withdrawal. By refinancing, you could get a second 401(k) loan at more favorable terms. If you are on the verge of default, refinancing helps you pay off the loan, and get more time to make 401(k) loan payments.

Potential Risks of Refinancing a 401(k) Loan

If the amount and term of the second 401(k) loan are not accurately calculated, the transaction could trigger a deemed distribution, and you will owe income taxes on the loan, and a potential 10% penalty if you are below 59 ½. Usually, the first and second 401(k) loans should not exceed the dollar amount limit, which is the lower of 50% of the vested balance or $50,000. Also, the two 401(k) loans must be within the maximum repayment period, which is 5 years, or longer if the loan was used to buy a house.

401(k) Loan Refinancing Example

John borrowed $15,000 from his 401(k) plan on January 1, 2018, with a repayment term of three years ending December 31, 2020. On January 1, 2019, John refinanced the 401(k) loan by borrowing an additional $10,000 with a term of 2 years ending December 31, 2021, which is within the permissible term of the original loan i.e. 5 years. At this time, the outstanding balance of the original 401(k) loan was $6,000. Therefore, the principal for the new loan will be $16,000, which includes the new 401(k) loan of $10,000 and the outstanding balance of the original loan.

Since the term of the second loan is within the maximum permissible term of the original loan i.e. 5 years, only the second loan will be considered to determine if it exceeds the 401(k) loan limit. Assuming John has a 401(k) loan limit of $50,000, the principal of the new loan i.e. $16,000 is below the loan limit, hence it cannot be considered a deemed distribution for tax purposes.