Can a 401(k) Be Used as Collateral? Risks and Alternatives, Explained

Collateral is referred to as an asset that a lender accepts as security for a loan, according to Investopedia. It works as a security for the lender. In case a borrower defaults on loan payments, the lender can seize the collateral to help recoup some or all of the losses. There are many types of collateral that lenders accept, including a home, car, bank savings deposits, and investments accounts. For people who have a 401(k) account, a question naturally arises. Can a 401(k) be used as collateral?

A 401(k) is a retirement plan offered by employers and has grown to become the most popular workplace retirement savings plan in the U.S. It is funded through the employee’s pre-tax paycheck deductions. The employer might or might not match a certain part of your contribution. However, there's a contribution limit and the IRS reviews it regularly. For 2022, you can contribute up to $20,500 to a 401(k) plan, up from $19,500 in 2021 and 2020.

There's a penalty of 10 percent if you withdraw from a 401(k) before you reach 59.5 years old. Since the account isn't easily accessible, people might think of pledging it as collateral to obtain a loan from somewhere else. However, that isn't an option. The IRS guidelines prohibit using funds in a 401(k) plan account to be used as collateral for a loan. There are certain risks involved in using a 401(k) as security for a loan.

The IRS considers your entire 401(k) account balance as a distribution in the year you used it as collateral. Therefore, the entire balance will attract a penalty of 10 percent (if you are below 59.5 years old) and it will also be taxed as ordinary income.

If the IRS finds out that you’ve used your 401(k) account as collateral, you might forego the tax benefits of your account.

One of the other benefits of having a 401(k) account is that it offers creditor protection through the Employee Retirement Income Security Act (ERISA). This means that if you owe money to a creditor or you filed for bankruptcy, the creditors can have access to your other assets but they can't seize your retirement money to settle a debt. However, if you use a 401(k) as collateral, you will lose creditor protection and the creditor can seize the funds in the account.

While accessing a 401(k) is slightly difficult, it doesn’t mean that there aren't ways to use it in times of hardship. Many 401(k) plans allow participants to take 401(k) loans. You may be able to borrow up to half of your vested balance, not exceeding $50,000. You will still be required to pay interest on the loan but it will get added to your 401(k) account, which will help it grow more.

Moreover, there are some exceptions in making penalty-free withdrawals. You can take a hardship withdrawal if it meets the criteria regarding the need and the amount. A hardship distribution, for example, can be used to pay college fees, medical expenses, funeral expenses, etc. You may be required to provide evidence of financial need when requesting a hardship withdrawal.