When Should You Take a Loan from Your Retirement Plan?

How Retirement Plan Loans Work

Most retirement plans that allow loans follow similar guidelines. Participants may typically borrow the lesser of:
– 50% of their vested account balance, or
– $50,000

The loan is repaid through payroll deductions with interest, usually over five years, although loans used for a primary residence purchase may have longer repayment periods. Some retirement plans allow you to make payments via ACH from your bank account.

An important feature is that the interest paid on the loan goes back into the participant’s own account, rather than to a bank. However, this does not eliminate potential downsides.

When a Retirement Plan Loan May Make Sense

While borrowing from a retirement account is not ideal in most circumstances, there are situations where it may be a reasonable option.

1. Purchasing a Primary Residence

Using a plan loan to help with a home purchase may be one of the more defensible reasons to borrow from a retirement account, if you have no other resources for a down payment, because you are using the retirement plan loan to help buy an appreciating asset that can lower your lifetime housing costs and increase overall asset values by building equity rather than paying rent. A 401(k) loan may also help avoid higher-interest borrowing or private mortgage insurance while supporting a long-term financial goal. Some plans allow longer repayment periods for home loans, which can make the payments more manageable.

2. Eliminating or Avoiding High-Interest Debt

If a participant is facing very high-interest debt, such as credit card balances with interest rates exceeding 20%, a plan loan may sometimes be a lower-cost alternative. Borrowing from your retirement plan might make sense here because the money you save on interest could make up for the smaller 401(k) balance. Paying off high interest debt like 20% is usually a smart move, since it’s much higher than what most investments earn in a year. But keep in mind, this saves money in the short term, while staying invested could lead to bigger gains over many years.  You should only take this approach if you have a clear plan to pay it back, so you don’t end up trading one debt for another or hurting your finances.

3. Short-Term Liquidity Needs

Temporary financial needs, such as emergency expenses, may occasionally justify a loan if the participant has no other accessible savings and wants to avoid early withdrawal penalties. Even in these cases, it’s important to view the loan as a last resort rather than a routine financial tool, to minimize detrimental impacts on retirement readiness.

When Participants Should Think Twice (Please Avoid)

In many situations, borrowing from a retirement plan may do more harm than good. The general rule is that if a loan is not to address an emergency that can’t be funded another way, or to improve your overall long-term financial situation, and instead the loan is used to purchase items that depreciate in value, it is generally advisable to avoid taking out a loan.

1. Funding Lifestyle Expenses

Taking a retirement plan loan for discretionary spending—such as vacations, luxury purchases, or nonessential upgrades—can undermine long-term financial security.
These types of expenses do not create lasting financial value, yet they remove invested assets from the market during the loan period.

2. Interrupting Long-Term Investment Growth

When funds are removed from a retirement portfolio, they are not invested in the market during the loan period. If markets perform well during the loan period, participants may miss out on investment gains that would have improved retirement readiness. Over time, even a relatively small loan can significantly impact long-term compounding.

3. Employment Changes

One of the biggest risks of a retirement plan loan occurs when a participant leaves their employer. Many plans require the loan to be repaid within a short window after termination. If it cannot be repaid, the remaining balance may be treated as a taxable distribution, potentially triggering both income taxes and early withdrawal penalties, and permanently reducing the size of the 401(k) account, because loan payments cannot be made unless a person remains an employee of the company.

4. Double Taxation Concerns

Although loan interest goes back into the account, it is typically repaid with after-tax dollars and may be taxed again when withdrawn during retirement. This can mean double-taxation and can reduce your wealth.

A Good Rule of Thumb

Before taking a retirement plan loan, participants should ask themselves three questions:
1. Is this expense necessary or discretionary?
2. Do I have other sources of funds available?
3. Will I be able to comfortably repay the loan without reducing my retirement contributions?

If the answers to these questions raise concerns, it may be worth exploring alternatives such as emergency savings, personal loans, or adjusting short-term spending.

The Bottom Line

Retirement plan loans can provide flexibility during certain financial situations, but they should generally be used sparingly and thoughtfully.

For major financial goals, such as purchasing a primary residence or for addressing high-interest debt, a loan may be a reasonable option in some circumstances, because it can be a positive economic tradeoff. However, using retirement savings for lifestyle spending or nonessential purchases can significantly harm long-term retirement outcomes.

Participants should remember that their retirement account is designed to support their future financial security and promoting and preserving that long-term growth should remain the priority.