Key Takeaways
- 401k loans are capped at the lesser of $50,000 or 50% of your vested balance.
- You repay yourself with interest, but the money is taxed twice and can derail if you change jobs.
- Defaulted loans become taxable distributions — plus 10% penalty if you are under 59½.
How a 401k Loan Works
A 401k loan lets you borrow from your own account. The legal limit is the lesser of $50,000 or 50% of your vested balance, reduced by your highest outstanding loan balance during the past 12 months. Most plans require repayment through payroll deductions over a maximum term of five years (longer terms are allowed for a primary residence). The interest rate is typically the prime rate plus one or two points, and here is the key feature: the interest you pay goes back into your own account, not to a bank. That sounds like a free lunch, but there are two serious costs. First, the borrowed money is out of the market — while you owe $20,000, that $20,000 is not compounding. Second, the interest is paid with after-tax dollars and will be taxed again when you withdraw it in retirement: a double tax that economists call the "double taxation" problem of 401k loans.
When a Loan Makes Sense
- Short-term, high-interest debt: paying off a 20% credit card with a 5% 401k loan saves real money — but only if you fix the spending that created the debt.
- Bridging a temporary cash crunch where the alternative is a 10%-penalized early withdrawal.
- Home purchase: many plans allow a longer repayment term for a primary residence, reducing the monthly bite.
When It Does Not
- You may change jobs. Most plans require full repayment within 60-90 days of leaving; if you cannot pay, the balance is treated as a distribution — taxable, plus 10% penalty if under 59½.
- You lose compounding on the borrowed amount for the life of the loan, which usually outweighs the interest you pay yourself.
- Payroll deduction risk: if you go on unpaid leave, missed payments can trigger default and immediate taxation.
Action Steps
- Check your plan's loan rules (minimum amount, fees, repayment term) in the summary plan description.
- Run the math: compare the loan interest you pay yourself against the market return you give up.
- If you take a loan, set up automatic repayment at the shortest term you can afford.
- Before changing jobs, know your plan's repayment deadline — and have a plan to repay in full if needed.
Worked Example: A $20,000 Loan
Consider borrowing $20,000 at 5% for five years while the market earns 7%. You repay $22,645 including interest — the interest goes into your account, which sounds great. But the $20,000 that was compounding at 7% in the market now compounds at your 5% loan rate inside the account, while your payments are made with after-tax dollars that will be taxed again at withdrawal. The net drag versus not borrowing is roughly the 2% spread on $20,000 over five years plus the double taxation of the interest — on the order of $2,000-$3,000 in lost wealth for a "cheap" loan. The loan still beats a credit card at 20% by a wide margin, but it is not free money. Use it to eliminate genuinely expensive debt or bridge a true emergency, repay early if you can, and never borrow when a job change is likely.
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The most common way a 401k loan goes wrong is the job-change deadline. If you leave your employer with an outstanding loan, you typically have until the due date of your federal income tax return (including extensions) for that year to repay the full balance. Miss it, and the IRS treats the outstanding amount as a deemed distribution — taxable income plus the 10% early-withdrawal penalty if you are under 59½. If you cannot repay, you still owe the tax on money you never actually received, which can be a serious cash-flow shock. A second trap is the double-tax effect: loan repayments come from after-tax dollars, and the same money is taxed again when withdrawn in retirement. A third is opportunity cost — borrowed money misses market gains, and the 5-6% interest you pay yourself rarely matches a 7-10% market return. Only borrow for genuine emergencies or to clear debt above 10% interest.