You Pay the Interest to Yourself, and It Still Costs You
A 401(k) loan is the most reasonable-sounding way to reach retirement money early. There is no credit check, the rate is modest, the interest goes back into your own account, and nothing is taxed. Each of those is true. What the description leaves out is that the borrowed money stops compounding, and that leaving your job — voluntarily or not — can turn the outstanding balance into a taxable distribution with a penalty attached.
- The answer:: Up to 50% of your vested balance, capped at $50,000, repaid in substantially level payments at least quarterly, within five years — longer if used to buy a principal residence.
- Not a taxable event:: A loan that performs to its terms is not a distribution. Nothing is reported as income and no early-withdrawal penalty applies.
- The real cost:: The borrowed money is out of the market for the term. On a long horizon that forgone growth dwarfs the interest rate, and the interest you pay yourself does not replace it.
- The separation trap:: Leave the employer with a balance outstanding and it must generally be repaid by your tax filing deadline for that year, or the unpaid amount becomes a taxed distribution, with the 10% penalty if you are under 59½.
Where the AI summary above gets this wrong
"A 401(k) loan is a good deal because you pay the interest to yourself instead of to a bank."
That's surface-true. Here's what it misses:
- Paying yourself interest does not make it free — The comparison is not against a bank loan's interest — it is against what the money would have earned invested. Repaying 6% to yourself on capital that would have compounded at 7% still leaves you behind, and the gap grows with the years remaining.
- The interest is repaid with after-tax money — Loan repayments come from take-home pay, so the interest is paid with dollars already taxed and will be taxed again on withdrawal from a traditional balance. It is one of the few places where the same dollar is genuinely taxed twice.
- Job loss converts it into a taxed distribution — This is the risk the framing entirely omits, and it correlates badly: people borrow when money is tight and lose jobs in the same conditions. An outstanding balance at separation generally becomes taxable income plus a penalty, in a year when income has just stopped.
01 What you can borrow, and on what terms
Plans are permitted, though not required, to offer loans. Where they do, the ceiling is generally the lower of $50,000 or 50% of your vested account balance, and a plan may set a lower limit of its own.
Repayment must be in substantially level payments, made at least quarterly, over no more than five years. The exception is a loan used to acquire a principal residence, which may run considerably longer. Repayments are almost always taken from payroll, which is why the loan tends to feel invisible while it is performing.
A loan that meets these conditions is not a distribution. Nothing is reported as income, no penalty arises, and the balance outstanding is not a withdrawal — it is a receivable owed to your own account.
Source: Retirement topics — plan loans
02 The cost the interest rate hides
The money you borrow leaves the investments. For the term of the loan it is not exposed to market returns, and the interest you pay back — while genuinely yours — is not the same as the growth it displaced.
The size of that gap depends almost entirely on how far you are from retiring. Borrowing $30,000 for five years costs little if you are three years out. With twenty years remaining, those same five years out of the market compound into a materially smaller balance at the end, even with every dollar repaid on schedule.
Two smaller costs compound it. Repayments are made with after-tax pay, so interest on a traditional balance is taxed again when withdrawn. And many people reduce or suspend contributions while repaying, which quietly forfeits any employer match on the suspended amount — usually the more expensive of the two, for the reasons set out in the cost of missing your match.
Shows: the compounding forgone while the borrowed money sits outside the market, assuming you repay in full and on schedule. Ignores: the interest you pay back to yourself, contributions you may suspend while repaying, and the tax consequences of a default.
03 What happens if you leave
This is the part that turns a manageable decision into an expensive one. If you separate from the employer with a loan outstanding, the balance generally must be repaid by the due date of your tax return for that year, including extensions. Miss that and the unpaid amount is treated as a distribution.
That distribution is ordinary income in the year of the default, and carries the 10% early-withdrawal penalty if you are under 59½ and no exception applies. The correlation is the cruel part: the circumstances that make people borrow are the same ones that end jobs, so the risk concentrates precisely where it can least be absorbed.
Where the need is genuine and a loan is not workable, a hardship distribution is the other route a plan may offer. It is immediately taxable and generally penalised, and it cannot be repaid — which makes it worse than a loan that performs, and better than a loan that defaults.
I do not think 401(k) loans are a mistake in the way they are usually described. Against a credit card at 22%, borrowing from yourself at 6% is plainly better, and people facing that choice are not being reckless. What I would want anyone to price honestly is the separation risk, because it is the one term that is not in your control and it correlates with the reason you borrowed. If the loan only works provided you keep the job for five years, that is not a loan — it is a bet on your employer, made at the moment you can least afford to lose it.
FAQ
How much can I borrow from my 401(k)?
Generally the lower of $50,000 or 50% of your vested balance, though a plan may set a lower limit or offer no loans at all. Repayment must be in substantially level payments at least quarterly, within five years — longer for a loan used to buy a principal residence.
Is a 401(k) loan taxable?
Not while it performs to its terms. A qualifying loan is not a distribution, so nothing is reported as income and no early-withdrawal penalty applies. That changes if it defaults, at which point the unpaid balance is taxed as a distribution.
What happens to my 401(k) loan if I leave my job?
The outstanding balance generally has to be repaid by the due date of your tax return for that year, including extensions. Anything unpaid is treated as a distribution — ordinary income, plus the 10% penalty if you are under 59½ and no exception applies.
Sources
Regulator references
- Retirement topics — plan loans · Internal Revenue Service · 2025The borrowing limits, the five-year repayment rule, and the level-payment requirement.Last verified: 2026-09-07
- Retirement plans FAQs regarding loans · Internal Revenue Service · 2025What happens on default and when an unpaid balance becomes a deemed distribution.Last verified: 2026-09-07
- Retirement topics — hardship distributions · Internal Revenue Service · 2025The alternative when a loan is not available, and why it is not repayable.Last verified: 2026-09-07
Calculator unit tests · the assertions this page's worked example is checked against, and their last result
Changelog
- 2026-09-07 — initial publish (new format)
Run this rule against your situation
See what this rule does to your own projection — month by month, to age 90.
Join the Waitlist
Jordan Reeves
Founder of Talk Through Wealth. A software engineer for over a decade before turning to retirement planning, Jordan built the projection engine after watching family members get fragmented, country-by-country advice that never reconciled. He writes about retirement the way the engine computes it: month-by-month, lifetime-long, and skeptical of any rule of thumb that hasn't been run through the math.