What Is a 401(k) Loan? And How Does It Work?

We can’t read your mind, but there’s a good chance the whole reason you clicked on this article is because you have a sudden need to pay for something expensive (car repairs, busted HVAC) and the money in your 401(k) is calling to you softly in the night.

Okay, maybe it’s not that dramatic.

But maybe you are facing a big expense, looking at your retirement account’s balance and wondering if a 401(k) loan is the right move.

So, let’s break down what it is and how it works.

What Is a 401(k) Loan?

A 401(k) loan lets you borrow money from your employer-sponsored retirement account with the understanding that you’ll need to return that money to your 401(k) over time (plus interest).

If you want to borrow money from your 401(k), you’ll need to apply for a 401(k) loan through your plan provider. Once your loan gets approved, you’ll sign a loan agreement that includes:

• The principal (the amount you borrowed)
• How long you have to repay the loan
• Your interest rate and other fees
• Any other terms that may apply

Since you’re technically borrowing your own money, most 401(k) loans get approved without much hassle and have relatively low interest rates. And because no banks or lenders are involved, nobody’s going to check your credit score.

Most plans will let you set up automatic repayments through payroll deductions, which means you’ll be seeing less money in your paycheck until the loan is paid off. Those payments—which include principal and interest—will keep going back into your 401(k) until the loan is paid off.

 

401(k) Loan Quick Facts

Rule	Details
Borrowing limit	Usually up to $50,000 or 50% of your vested balance, whichever is less1
Repayment	Maximum loan period of five years.
Interest	Interest must be paid on the loan, but that interest goes back into your own 401(k) account.
Credit check	No credit check is required to take out a 401(k) loan.
Job loss risk	If you leave your job with a loan balance, you need to repay the full balance pretty quick or you’ll owe taxes and penalties.

What Are the 401(k) Loan Rules?

The IRS loves taxing the living daylights out of your money, but sometimes it seems like they love rules even more. Here are a few of the most important ones for 401(k) loans:

• Loan terms: The terms of the loan depend on your employer’s plan. Since every plan is different, double check what’s allowed in your situation.
• Borrowing limits: According to the IRS, you can borrow up to $50,000 or 50% of your vested 401(k) balance, whichever is less. But if half of your vested balance is $10,000 or less, your plan may still allow you to borrow up to $10,000 (again, not all plans offer this).²
• Repayment period: You have a maximum of five years to repay the loan. Payments are usually made by automatic payroll deductions with your employer-sponsored plan.
• Interest rate: Interest is usually the prime rate (what banks charge their best corporate clients) plus around 1–2%.³ For example, if the prime rate is 6%, interest on your 401(k) loan could be around 7–8%.
• Taxes and penalties: You risk 401(k) loan penalties, plus potentially higher taxes, if you leave your job before your loan is paid off.

Yep, you read that right. Things can change drastically if you leave your job before your 401(k) loan is repaid. Here's how it could play out in real life.

How Does a 401(k) Loan Work?

Let’s say you’ve been investing for a while but still have consumer debt hanging around. Your 401(k) balance has grown to $150,000. And since you've been with your employer several years, your retirement funds are fully vested (in other words, they’re yours).

One day you say to yourself, Life’s short—I’m gonna take a trip to Europe this summer. I deserve this. So, you pull out all the stops. You still have debt and don’t have enough money in savings, so you decide to borrow $20,000 from your 401(k). That’ll buy you a few days enjoying the fine life in French wine country, a day yachting the Amalfi coast, and a few days touring the Swiss Alps by motorcycle. Like you said, life is short!

Do THIS Instead of Borrowing From Your 401(k)

With that decided, you make the call to your 401(k) plan administrator. Since your loan request for $20,000 is below the borrowing limit set by the IRS, you’re approved at 8% interest.

You take the trip. And you take all the photos. You have the best time you possibly can. In the back of your mind, though, you keep wondering if you’re going to regret doing it with more debt.

But when you get back home, your friends are envious of your tan. They love your stories. And you’re more popular than ever at work.

Then life smacks you upside the head. Your home’s worn-out HVAC system finally bites the dust (womp womp). How will you cash flow those repairs now that you’re making monthly $500 payments on your 401(k) loan? You thought you “wouldn’t feel it” because your payments are just an automatic payroll deduction—except you do feel it. It’s a giant pay cut. Now you’re staring down the barrel of a five-year repayment plan with zero margin for error.

Okay, let’s pause the story for a moment to talk about opportunity cost—what you miss out on when saying yes to one thing means saying no to another:

• That $20,000 401(k) loan you made to yourself pulled retirement money out of the market. Now, instead of earning an average of 11% in the market, that money’s only “earning” 8% through the interest you’re paying yourself on the loan. And unlike years of compounding on your investments, that 8% is coming out of your pocket—after taxes. Not exactly a smart move.
• You don’t just miss out on growth—you also miss out on compounding interest for five years. That’s costly because, if you had kept that same $20,000 invested for 20 years, it could have grown to almost $200,000!
• And worse, when you start making withdrawals in retirement, you’ll pay taxes on that money again. Yep, taking out a 401(k) loan basically signed you up for double taxation. Double yikes!

Okay, back to our example. Remember the Amalfi coast, the busted HVAC and all the rest?

Now it’s three months later. Your HVAC system is still busted, and you’re stressed (but at least you have all those European memories).

When your phone pings after work on a Friday, your heart sinks. You’ve just been laid off (by email, no less). Now you’re sitting at home with no HVAC—and no job—asking yourself, What happens now?

What happens now is that the balance of your loan is due in full. Since you’ve only paid it down to about $19,000, your plan administrator offsets the loss by subtracting $19,000 from your 401(k) balance so they can balance their books.

Under IRS rules, that offset just became a withdrawal. And since you’re under age 59 1/2, you only have until Tax Day (a few months away) to roll over that money into a new 401(k) or IRA.⁴

 

Let’s sum it up: That was a nice trip to Europe, but now your HVAC system is broken, you owe the IRS thousands of dollars, and you’re unemployed. Not to rub it in, but is it fair to say you regret having ever heard “loan” tacked onto the end of 401(k)?

What Is the Difference Between a 401(k) Loan and a 401(k) Withdrawal?

So, if it’s not a good idea to borrow from your 401(k), why not just bite the bullet and take an early withdrawal? Well, neither option is a great choice in our book because both put your retirement at risk. But there are some important differences—mainly in how they affect your taxes.

401(k) Loan vs. 401(k) Withdrawal

	401(k) Loan	401(k) Withdrawal
Repayment	Must be repaid to the account, typically through payroll deductions.	Doesn’t need to be repaid—the money is permanently removed from the account.
Taxes	Generally not taxed if the loan is repaid on time.	Usually treated as taxable income in the year it’s received.
Penalty	No early withdrawal penalty if terms are met.	A 10% early withdrawal penalty often applies if you’re under age 59 1/2.
Growth	Repaid interest goes back into the account, but the borrowed amount misses out on market growth and compound interest.	Permanently reduces the balance, ending any potential market growth on the withdrawn amount.
Job Loss	Often must be repaid shortly after leaving a job or the remaining balance becomes a taxable distribution.	No repayment is required, regardless of employment status.
Ramsey Says	Avoid it.	Avoid it whenever possible.

401(k) Withdrawal

When you withdraw money from your 401(k), that money is treated like ordinary income—so you’ll owe taxes on it at tax time (along with a hefty early withdrawal penalty if you’re under age 59 1/2). But unlike a loan, a withdrawal doesn’t have to be repaid.

Depending on the situation you’re in (vacationing on the Amalfi coast doesn’t count), you might qualify for a hardship withdrawal. That would allow you to take money out of your 401(k) without an early withdrawal penalty under special circumstances (you’d still owe income taxes, though). 

But there are other ways to cash flow a tough spot. We’ll cover a few of those in a moment.  

401(k) Loan

When you get a 401(k) loan, you’re borrowing from your retirement and will have to pay that money back. You’ll typically repay the loan, with interest, over a maximum of five years. Since the money you borrow isn’t treated like income, you won’t owe taxes or pay an early withdrawal penalty on the loan.

But here’s what happens if you leave (or lose) your job with an outstanding balance on your 401(k) loan: If you don’t repay your loan in full by the time your tax return is due, Uncle Sam will send you a huge bill for taxes (and charge you a penalty too).

Should You Take Out a 401(k) Loan?

If it isn’t obvious by now that we don’t recommend taking out a 401(k) loan, there’s not much else we can say. Don’t do it. It’s not a lifeline. Think of it instead as a heavy weight that could sink your financial future.

Here are three huge reasons why you should never consider a 401(k) loan:

1. You put your retirement at risk.

Here’s the deal: Your 401(k) is for retirement, not emergencies, debt payoff or vacations. To borrow from your retirement is to steal from your future.

For example, if you borrowed as little as $10,000 from your 401(k) at 25 years old, that one choice could cost you dang near $800,000 by the time you’re 65. It could also require you to stay on the job a lot longer than you want.

2. You become too dependent on your employer.

If you leave your job for whatever reason, you may only have a few months to pay back the entire balance of your 401(k) loan. The borrower is a slave to the lender.

Even though most people choose a five-year repayment plan for their 401(k) loans, about half of workers have been at their jobs less than four years.⁵ Do you see the problem here? Okay, so you’re happy at your job today. But what about a year or two from now? What if opportunity knocks and you can’t answer because you’re still paying off that 401(k) loan?

The bottom line is, debt limits your ability to choose. A 401(k) loan can tie you to your job. If you end up desperately wanting to leave or have an exciting job opportunity, you may not be able to do anything about it.

3. You pay taxes on your repayments—twice.

Normally, contributing to your 401(k) comes with some great tax benefits. If you have a traditional 401(k), for example, your contributions are tax-deferred.

But if you have a 401(k) loan, the payments you make get no special tax treatment (beyond the moment you get the loan). Effectively, they’re taxed twice.

That’s because, first, your 401(k) loan repayments are made with after-tax dollars (meaning the money has already been taxed once). Second, you’ll pay taxes on that money again when you make withdrawals in retirement.

If there’s anything worse than paying taxes, it’s paying them twice.

What Are the Alternatives to Taking Out a 401(k) Loan?

Listen. You always have options.

If you’re in a place where borrowing from your 401(k) is tempting, there's probably a bigger money problem lurking.

Start by prioritizing the basics: Food, utilities, shelter and transportation come before everything else. Give every dollar a job with an EveryDollar budget. (You’ll gain a lot of margin by dropping subscriptions and not eating out, for starters.) Because if you don’t tell your money where to go, you’ll always wonder where it went.

And if the math still won’t math, you can make ends meet by increasing your income. A short-term side hustle can solve a short-term problem without nuking your long-term goals.

In other words, your 401(k) is for retirement. Don’t use it to fix problems your budget should handle.

What you really want to do here is build enough margin to keep a small emergency from turning into a full-blown crisis. That’s exactly why we created the 7 Baby Steps:

• Baby Step 1: Save $1,000 for your starter emergency fund.
• Baby Step 2: Pay off all debt (except the house).
• Baby Step 3: Save 3–6 months of expenses in a fully funded emergency fund.

That lays the foundation for Baby Step 4, when you begin investing from a position of strength—not desperation. That’s the Ramsey way.

Talk With a Financial Advisor

Still have questions about your 401(k) or what a 401(k) loan would mean for your financial future? Maybe it’s time to talk with a trusted financial advisor.

Our SmartVestor program connects you to pros you can trust. With an investment pro in your corner, you won’t have to make huge financial decisions on your own.