Quick summary
A 401(k) loan lets you borrow from your own retirement account and repay it with interest. It removes cash from your invested balance, which reduces compound growth while the loan is outstanding. The loan limit is generally the lesser of 50% of your vested account balance or $50,000 (subject to plan rules). If you leave your job with an outstanding balance, the unpaid amount is often treated as a distribution and becomes taxable and possibly subject to a 10% early-withdrawal penalty. (IRS — “Retirement Topics: Loans”, irs.gov)
How 401(k) loans typically work
- Eligibility and plan rules: Not all plans allow loans. Your plan document and administrator outline eligibility, maximums, repayment periods, and whether primary-residence loans are permitted.
- Loan limits: Federal guidance generally limits loans to the lesser of 50% of your vested balance or $50,000, though your plan may impose lower caps.
- Repayment: Loans are commonly repaid through payroll deductions over a set term (often up to five years for general-purpose loans; longer terms may apply for a home purchase). You pay interest to your own account; however, that interest is paid with after-tax dollars and can be taxed again on eventual distribution (the so-called “double taxation” concern).
- Default rules: If you don’t repay the loan per the plan terms, the outstanding balance is treated as a distribution—taxable income and potentially subject to the 10% early-withdrawal penalty if you’re under 59½. If you leave or are terminated, many plans accelerate the repayment requirement or treat the balance as a distribution.
Sources: IRS (irs.gov), Consumer Financial Protection Bureau (consumerfinance.gov).
Pros — Why someone might use a 401(k) loan
- Speed and access: Loans can be faster and simpler than applying for a bank loan, personal line of credit, or other financing.
- Lower interest than unsecured credit: Interest rates are often lower than credit cards or some personal loans. The interest also goes back into your own account instead of a bank’s pocket.
- No credit check: Because you’re borrowing your own money, plan administrators typically won’t run a credit check, so your credit score won’t be affected by the loan application itself.
- Avoid early-withdrawal penalties: A loan is not an immediate taxable distribution if repaid on time, so it avoids the 10% penalty for early withdrawals that would otherwise apply.
Real-world nuance: In my experience working with clients, a 401(k) loan made sense when it replaced high-cost credit (e.g., credit card debt) and the borrower had stable employment and a clear repayment plan.
Cons — What you should watch out for
- Opportunity cost: Money removed from the market can’t compound. Even though you pay yourself interest, foregone market returns usually exceed the loan interest rate, especially in bullish markets.
- Double taxation concern: Loan repayments are made with after-tax dollars; when you later withdraw those funds in retirement, distributions are taxed again—effectively taxing the repaid portion twice.
- Job-change risk: If you leave your employer (voluntarily or not), many plans accelerate repayment or treat remaining loan amounts as taxable distributions. This common scenario is one reason loans can have hidden risks.
- Reduced contributions: Many borrowers reduce 401(k) contributions while repaying a loan because of tighter cash flow, cutting off new employer match dollars and further lowering retirement savings.
- Possible plan restrictions: Plans can limit how many loans you can have or prohibit them entirely.
Example: A client borrowed $20,000 to pay off credit-card debt. They saved on interest costs but reduced their retirement contributions during repayment and later changed jobs, which required them to treat the unpaid balance as a distribution and pay taxes on it.
Alternatives to a 401(k) loan (and when they may be better)
- Emergency fund: The best alternative is an emergency cash reserve (3–6 months of expenses) to avoid borrowing from retirement.
- Low-interest personal loan or home equity loan: If you qualify, an unsecured personal loan or home equity line of credit (HELOC) can keep your retirement savings invested and may have competitive rates.
- Balance transfer or 0% APR card: For short-term credit needs, a 0% promotional credit card or balance transfer can be cheaper than a 401(k) loan—if you can pay it off before the promo ends.
- Borrow from family: While not ideal for everyone, a documented family loan with clear terms can avoid retirement disruption.
- Roth conversion strategy: In some cases, preserving tax diversification (Roth vs. traditional) is smarter than tapping a 401(k). See our guides on Roth conversion planning and comparing Roth accounts for related tax strategies: Roth 401(k) vs Roth IRA: When to Use Each for Tax Diversification and How to Create a Roth Conversion Plan Over Several Years.
When alternatives win: If you’ll lose an employer match, expect a job change, or the loan would force you to cut contributions, alternatives usually produce a better long-term outcome.
Decision checklist — Should you take a 401(k) loan?
- Is this an emergency you cannot solve with savings, short-term credit, or other options? If not, avoid the loan.
- Can you repay the loan on schedule even if your financial situation changes (job loss, reduced hours)? Build a backup plan for repayment.
- Will borrowing cause you to stop contributing or lose employer match dollars? Calculate the cost of lost employer match and lost market growth.
- Do you fully understand your plan’s rules if you separate from the employer? Confirm the post-employment repayment window and tax treatment.
- Compare true after-tax costs: include opportunity cost, double-taxation effect, and lost future employer match.
Use a simple calculator: estimate the expected annual market return you’d lose by removing the balance, then compare that to the interest you’ll pay yourself plus the lost employer match.
Example calculation (simplified)
Assume you borrow $25,000 for five years, the plan charges an interest rate of 5%, and your expected long-term market return is 7%:
- Interest paid to your plan (5%) is lower than the market return you forgo (7%), so your net retirement position likely falls behind even if you repay the loan on time.
- If you stop contributing and lose a 3% employer match, the long-term retirement cost increases materially.
Always run numbers specific to your situation or work with a planner.
Common questions (short answers)
- What happens if I leave my job with an outstanding loan? Many plans treat the balance as a distribution; it becomes taxable income and may be subject to a 10% penalty if you’re under 59½. Confirm the plan’s accelerated repayment terms. (IRS — “Retirement Topics: Loans”)
- Can I have multiple 401(k) loans? Plans often limit the number of outstanding loans; check your plan document.
- Is 401(k) loan interest tax-deductible? No—the interest you pay on a 401(k) loan isn’t tax-deductible.
Practical tips before you borrow
- Read your Summary Plan Description (SPD) and ask HR or the plan administrator for the loan-policy details.
- Keep contributing if possible—at least enough to get the employer match.
- Create a written repayment contingency plan in case of unexpected job loss.
- Treat the loan as a last-resort option; consider negotiating payment plans with creditors first.
Sources and further reading
- IRS, Retirement Topics — Loans: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-loans
- Consumer Financial Protection Bureau, “How retirement accounts and loans work”: https://www.consumerfinance.gov/ask-cfpb/what-is-a-401k-loan-en-1813/
- Fidelity, “401(k) loans”: https://www.fidelity.com/retirement-accounts/plan-loans
For tax-sensitive strategies and Roth planning that can affect whether you tap retirement savings, see our related guides: Roth 401(k) vs Roth IRA: When to Use Each for Tax Diversification and How to Create a Roth Conversion Plan Over Several Years.
Professional disclaimer
This article is educational and not personalized financial or tax advice. Rules for retirement plans and loans depend on your plan document and current tax law; consult a certified financial planner or tax professional for guidance specific to your circumstances.
