401k Loans: When They Help and When They Hurt

Jun 13, 2025 | 7 min read

The classic spaghetti western film The Good, the Bad, and the Ugly has always resonated with me, especially its three-part story telling method. Borrowing that simple structure, I break down 401(k) loans the same way: first the advantages, then the drawbacks, and finally the worst-case scenarios.

Understanding 401k loan basics

A 401(k) loan lets you borrow from the vested balance in your workplace retirement plan, typically up to 50% of what you own, with a cap of $50k. The loan is not a taxable distribution because the plan administrator cuts a check to you and records a promissory note inside the account. You then repay the principal plus interest through payroll deductions. If the loan is used to buy your primary home, many plans allow a longer payoff window. Interest is set by your 401(k) loan policy and every payment puts the borrowed cash and the interest back into your account, so in effect you pay yourself.

Below is the way I frame the conversation: outline the clear advantages — The Good, elaborate on the often overlooked trade-offs — The Bad, and caution against the worst-case scenarios that can derail a retirement plan — The Ugly.

THE GOOD

If used wisely, 401(k) loan presents a number of attractive attributes 

1. Quick access to cash. If your plan allows loans, approval is usually just a few clicks away. There is no credit check and no bank paperwork.

2. Relatively low interest that stays in your account. Plans typically charge a prime rate  of around 7% (as of June 2025) plus 1%. The interest you pay goes back to your own balance, so the out-of-pocket cost is often lower than a personal loan or credit card.

3. No current income tax or early-withdrawal penalty when you repay on schedule. Because the transaction is treated as a loan rather than a distribution, taxes and penalties do not apply as long as payments stay on track.

4. Automatic payroll repayment. Installments come straight from each paycheck, which helps prevent missed payments.

5. Flexible terms. Most loans run from 1 to 5 years, and plans usually allow a longer payoff period for a primary residence. You can pay off early with no additional fee.

6. Temporary breathing room. When used sparingly a loan can bridge a brief cash crunch such as covering sudden moving expenses before a work reimbursement arrives or help clear high interest credit card debt once spending habits are under control.

THE BAD

Taking on a 401(k) loan can present a range of potential drawbacks and considerations:

1. Lost compounding. Money that leaves the market for even a few years misses any gains during that period. In real-world projections, a 30 year old who borrows $50k can finish retirement with more than $100k less than a peer who never borrowed. See Chart A on how loans can reduce your retirement balance

   1. Money that leaves the market for even a few years misses any gains during that period. Chart B illustrates this perfectly: it compares two scenarios over a 40 year career. The top chart shows how someone with constant 401(k) contributions reaches $1.35 million by age 65, while someone who takes loans and withdrawals ends up with $368,300 less, only $983,600. The bottom chart shows the timing of when loans and withdrawals occurred, demonstrating how even temporary interruptions in contributions can permanently damage long term growth.

2. Double taxation of repayment dollars. You repay the loan with after-tax income, but once the money returns to the plan it becomes pre-tax again. When you draw that balance in retirement, it is taxed a second time. To illustrate this as an example, let’s take a look hypothetical scenario below

   1. Let’s say you have a credit card of $20k with a 15% interest rate and you are making minimum payments. That means you are paying the credit card company $3,000 per year in interest and that will probably continue with only minimal payments for a number of years. After 5 or 6 years you may have paid the credit card company $15k+ in interest on that $20k balance.

      Instead, you take a 401(k) loan for $20k, pay off your credit cards, and then pay back the loan over the 5-year period, you will essentially have paid tax on the $20k as you make the loan payments back to the plan. If you’re in a 25% tax bracket, the tax bill will only be $5,000 spread over 5 years versus paying $2,000 in interest to the credit card company every year. Once you retire, you will be taxed again on that $20k balance.

3. Possible loss of employer match. Tight cash flow during repayment often leads borrowers to reduce their 401(k) withdrawals, so they miss out on the company’s matching dollars.

4. Plan restrictions. Some plans do not allow loans at all. Others limit the number of outstanding loans or set caps below the IRS maximum of 50% of the vested balance, up to $50k dollars.

5. Contribution slowdown. Many borrowers pause new contributions while repaying, which further reduces future balances. 

6. Administrative fees and quirks. Record keepers may charge origination or quarterly maintenance fees. Payroll errors can push a loan into default even when the borrower expects deductions to start automatically.

7. Behavioral pitfalls. Easy access can tempt you to dip into your retirement savings again and again. Repeated loans keep your balance from growing for years and ultimately defeat the plan’s main goal: building a secure nest egg for retirement.

Chart A: The Long-Term Cost of 401(k) Loans (growth comparison)

Source: J.P. Morgan Asset Management. Guide to Retirement (March 2025).

THE UGLY

Here are the ways that taking a 401(k) loan can backfire:

1. Job change or layoff. Leaving your employer usually triggers a balloon payment due by the next tax-return deadline. Miss that deadline and the unpaid balance becomes a taxable distribution. If you are younger than 59 1/2, add a 10% early-withdrawal penalty. 

2. Plan termination. If the employer shuts down or merges the plan, outstanding loans can be called immediately. The IRS may let you roll the balance into an IRA, but you still need fresh cash at a time you might be unemployed.

3. Market whiplash. Pulling funds during a bull market can mean buying back at higher prices, the classic sell low buy high mistake. Chart A demonstrates how costly it is to be out of the market during critical periods. Looking at S&P 500 performance from 2005 to 2024, a $10,000 investment that stayed fully invested grew to $71,750. But missing just the 10 best days dropped returns to $32,871, less than half the gains. This shows why taking 401(k) loans during market upswings can be particularly damaging to long term wealth.

4. Tax shock. If your $20k balance becomes taxable at 24 percent, you will owe $4.8k in tax and a $2k early withdrawal penalty. If you cannot pay right away, the IRS will charge interest.

5. Permanent leakage. Even when repaid, lost years of compounding cannot be recovered. Chart B shows the permanent damage: over a 40 year career, the gap between consistent savers and those who take loans grows exponentially. By age 65, someone who took loans throughout their career ends up with $368,300 less than their disciplined counterpart, a massive penalty that can't be made up even if all loans were eventually repaid.

Chart B: Missing the Market’s Best Days (S&P 500 Performance)

Performance of a $10,000 investment between January 3, 2005 and December 31, 2024

Source: J.P. Morgan Asset Management. Guide to Retirement (March 2025).

Final Thoughts

A 401(k) loan isn't good or bad by itself. It can make sense when you need money for a short time for something important, when you've already tried cheaper ways to get cash, and when you can still make payments even if you lose your job. It's usually a bad idea when it covers ongoing money problems or might end up costing you big tax bills and penalties.

Always compare the true cost (the money your retirement account won't grow, plus possible taxes and fees) against other options like using your emergency savings, cutting spending temporarily, getting a 0% credit card offer, or borrowing from family. Only borrow from your retirement if you're sure you won't regret losing that growth later, and only if you can handle the loan payments even during tough times. Your retirement money has one purpose: to be there when you stop working. Treat borrowing from it like borrowing something precious from a good friend.

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IMPORTANT DISCLAIMERS

Past performance is no guarantee of future returns

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