What are the tax implications of taking a 401(k) loan in 2025?

A 401(k) loan is not a taxable distribution, so it does not trigger income tax or the 10% early withdrawal penalty. However, there are significant tax implications to understand.

How 401(k) loans work:

• You can borrow up to the lesser of $50,000 or 50% of your vested account balance
• Repayment term is generally 5 years (longer if used to buy a primary residence)
• You pay interest (typically prime rate + 1%) to yourself, back into your own account
• Payments are made through payroll deductions with after-tax dollars

The double-taxation problem: Loan repayments (including interest) are made with after-tax dollars. When you eventually withdraw those funds in retirement, they are taxed again as ordinary income. This effectively means the repaid amount is taxed twice. For example, if you are in the 22% bracket, you need to earn $6,410 to repay $5,000 (after taxes). Then you pay tax again on that $5,000 when you withdraw it in retirement.

If you leave your job: Outstanding 401(k) loans generally must be repaid by the tax filing deadline (including extensions) of the year you leave employment. If you cannot repay, the outstanding balance is treated as a taxable distribution and subject to income tax plus the 10% penalty if you are under 59 1/2. Some plans allow you to continue making payments after separation.

Opportunity cost: The borrowed funds are no longer invested in the market. If your 401(k) would have earned 8% annually but you are paying yourself 5% interest on the loan, you lose 3% in potential growth. Over 5 years on a $30,000 loan, this could cost you thousands in lost compounding.

When a 401(k) loan might make sense: To avoid high-interest debt (credit cards at 20%+), as a bridge during a short-term emergency, or for a primary home purchase when you are confident of remaining with your employer.