When 401(k)s are brought up in discussions, what's the first thing that comes to mind? For most people, saving for retirement probably ranks near the top of that list.

However, 401(k)s are more than just a long-term savings vehicle. Your tax-advantaged retirement account can also be a source of liquidity if money ever gets tight.

That said, your 401(k) is a long-term investment vehicle—not a casual savings account—so it probably shouldn't be the first source of funds to reach for in an emergency.

Borrowing from your 401(k) also comes with unique risks. If you fail to repay your 401(k) loan on time, for instance, you’ll owe additional taxes and penalties.

Then again, if you’ve exhausted all your other resources and have no way to meet urgent financial obligations, borrowing from your 401(k) account could be a move worth considering.

So, when does it make sense to borrow from your 401(k)? Before we get to that, let’s briefly address how 401(k)s work.

401(k) retirement plans: the basics

What is a 401(k)?

A 401(k) is a tax-advantaged retirement saving and investment plan that employers offer as part of an employee benefits package. Every year, you can contribute a fixed amount to your 401(k), and most employers will match your contributions up to a set amount or percentage.

How does a 401(k) work?

A 401(k) is a defined contribution plan, which means the balance in your account hinges on your contributions and the performance of your investments decisions over time. To contribute to your 401(k), reach out to your employer to sign up. You may even discover that you’re already automatically enrolled.

Once you’ve funded your 401(k), you can invest in securities like stocks, bonds, exchange-traded funds (ETFs), REITs, or mutual funds. Your 401(k) balance will grow over time through capital gains, dividends, and interest—all of which you can withdraw when you hit 59 ½.

Types of 401(k) plans

There are two types of 401(k) plans—the traditional 401(k) and the Roth 401(k). They differ based on when you enjoy your tax benefits:

• With a traditional 401(k), you make pre-tax contributions, reducing your taxable income immediately. Your invested funds grow tax-deferred until you withdraw them at retirement, at which point they become taxable as ordinary income.

• In a Roth 401(k), you make after-tax contributions. You don’t receive an upfront tax deduction in the year you contribute, but you get to enjoy tax-free withdrawals upon reaching 59 ½.

Benefits of 401(k)s

A well-managed 401(k) can be an excellent retirement savings plan. Here are some features that make it an appealing investment strategy.

Tax advantages

Whether you opt for a traditional or a Roth 401(k), both plan types offer significant tax advantages. With a traditional 401(k), you get upfront tax deductions and tax-deferred growth. With a Roth 401(k), you unlock access to tax-exempt growth and withdrawals in retirement.

These tax advantages allow you to compound your savings more rapidly and accumulate a larger retirement nest egg than if you were to invest inside a standard taxable brokerage account.

High contribution limits

You can contribute nearly 3.5 times more in a 401(k) than you can in a traditional or Roth Individual Retirement Account (IRA).

In 2023, you can save $22,500 in a 401(k) or $30,000 if you’re 50 or older, not including employer-matching contributions. By contrast, you can only contribute $6,500 (or $7,500 if you’re 50+) to either a traditional or Roth IRA.

If you’ve maxed your core 401(k) contribution limit and still want to save more, you may be able to take advantage of voluntary after-tax contributions. Though not all 401(k) plans permit voluntary after-tax contributions, those that do allow big savers to contribute up to a combined $66,000 in regular elective deferral, employer-matching, profit-sharing, and voluntary after-tax contributions. That means you can contribute up to $43,500 more to your 401(k) per year—an excellent perk for high-income earners with money to spare.

Employer matching 

Many employers will match the amount you contribute to your 401(k) account up to a certain percentage or amount—a source of “free money” that can help beef up your savings. 

For example, if you earn $60,000 a year and contribute 5% of your income, or $3,000, to your 401(k), your employer may throw in a $3,000 match, doubling your 401(k) contributions. Employers use this strategy to attract and retain talent, and it’s generally a good idea to contribute (at the very least) up to your employer’s match.

While 401(k)s are a powerful way for workers to save for retirement, these accounts come with some restrictions and rules that you need to know.

401(k) withdrawal penalty and other rules 

There are two ways to withdraw from your 401(k) if you're younger than 59 ½ and still employed by the company managing your 401(k) plan.

First, you can make a hardship withdrawal. While these withdrawals don’t attract the 10% early withdrawal penalty tax, hardship withdrawals are nonetheless taxable events, and the IRS will withhold 20% of your early withdrawals for taxes. For example, If you withdraw $10,000, the IRS will withhold $2,000, leaving you with $8,000.

Additionally, hardship withdrawals must be made under exceptional circumstances of “immediate and heavy” financial need, including but not limited to medical expenses, child support, disability, and death.

However, if your early withdrawal is not covered by any exception stipulated by the IRS, it will not qualify as a hardship withdrawal, and you’ll be charged a 10% penalty (in addition to ordinary income taxes) on the amount withdrawn.

To use the earlier example, if your $10,000 withdrawal did not qualify as a hardship withdrawal, you'd incur an additional early withdrawal penalty of $1,000, leaving you with $7,000 after taxes (or less, depending on your effective tax rate).

Suffice to say, early withdrawals are not very tax-efficient. This takes us to our next option: a 401(k) loan. A 401(k) loan allows you to temporarily withdraw from your 401(k) plan and pay the funds back with interest. We’ll discuss 401(k) loans in more detail in the following section.

Should you take out a loan from your 401(k)?

A 401(k) loan allows you to borrow from your retirement account and pay it back with interest within five years. While financial advisors usually don’t recommend taking out a 401(k) loan on a whim, it can be a low-interest way to get cash if you’re ever in a pinch. This section will discuss when 401(k) loans are beneficial along with their borrowing restrictions.

401(k) loans: What you need to know

A 401(k) loan should be your last resort for getting funds. After all, your retirement account is for saving and investing, and you should do your best to limit unnecessary distributions during your working years. That said, if you need money urgently and have limited options, a 401(k) loan can come in handy.

When you take out a 401(k) loan, you borrow against the value of your retirement account. Not all 401(k) plans permit loans, but if your employer’s plan does, you may be able to borrow up to $50,000 or 50% of your vested balance, whichever is less.

Typically, you’ll need to repay your 401(k) loan within five years, unless you’re using the loan proceeds to buy a primary residence. There is no penalty for paying off your loan early.

IRS rules indicate that principal and interest payments should be made at least quarterly in substantially equal amounts. Your loan administrator will calculate your interest rate based on the current prime rate, plus a spread of one or two percentage points.

Interestingly, the interest you pay goes back into your 401(k) account to help keep your retirement account on track. That means you’re effectively paying yourself interest when you take out a 401(k) loan.

Like most other loans, you’ll incur origination fees that usually range between $50 and $100. Some 401(k) loans come with maintenance costs, which will run you another $25 to $150 per year. Unfortunately, these fees are collected by your plan administrator and do not end up back inside your 401(k) account.

If you switch jobs or get laid off, you’ll have until the tax return filing deadline for the tax year to pay off your outstanding balance or roll it over into another retirement account. Failure to do either and your employer will treat the unpaid balance as a distribution, which will attract income taxes and an additional 10% early withdrawal penalty.

When is it a good idea to borrow from your 401(k)?

Borrowing from your 401(k) could be a good option for you if you’ve exhausted all other sources of savings, are responsible with debt, and have a realistic plan for paying back your loan. Here are some situations when it might make sense to borrow from your 401(k).

Short-term liquidity needs

When you have a short-term financial emergency, a 401(k) loan is one of the quickest and easiest ways to get funds. There is no lengthy application process, and unless you violate the required repayment rules, there are no tax consequences either.

Avoid late payments or pay off high-interest debt

If you have lots of high-interest debt or loans that you can’t afford to pay off, a 401(k) loan could come in handy. Borrowing from your 401(k) to consolidate your debt not only helps you save on interest and late fees but also allows you to reinvest the interest you pay yourself back into your 401(k) account. Additionally, a 401(k) loan has no impact on your credit score.

As a down payment for your home

Homes are expensive, and coming up with the downpayment for one can be stressful. For this reason, a 401(k) loan could provide you with a much-needed source of funds.

While 401(k) loans usually come with a five-year term, some plans will extend your term up to 15 years if you’re using your 401(k) loan’s proceeds to purchase a primary residence.

…Or not

While there are select situations where taking out a 401(k) loan could be a good idea, it may not be the best option under other circumstances.

Loss of potential gains

401(k) loans are attractive because of their fairly low interest rates. Or even better, they’re technically interest-free, since all interest is remitted to your 401(k) account.

But at what cost? Whenever you take out a loan from your 401(k), you’re borrowing money that could otherwise have been invested in higher-yielding assets like equities and real estate.

In other words, even though you’re borrowing from yourself, there’s still an opportunity cost to borrowing from your 401(k), since you forgo other investments that you could’ve made with your funds had you not borrowed them yourself. 

Employer attachment

Another downside is that you’ll have to repay your 401(k) loan sooner than five years if you quit your job or get fired, unless you’re able to successfully roll it over into another retirement account.

Worse, if you miss the deadline for repayment, your 401(k) loan will be considered a distribution, meaning you’ll be charged a 10% early withdrawal penalty on top of regular income taxes. This is a steep price to pay—yet it’s a very real risk for anyone with an outstanding 401(k) loan.

Holding off on your contributions

Some 401(k) plans prohibit additional contributions until you’ve completely repaid your loan. Since your employer can’t match what you don't contribute, you miss out on “free money”—not to mention the contributions you would’ve made yourself.

And even if your 401(k) plan allows you to continue making contributions, you may not afford to repay your loan and make contributions simultaneously. This lapse in contributions could result in a smaller nest egg upon retirement.

Summing things up

Before borrowing from your 401(k), ensure that you’re doing it for the right reasons. Your retirement account should not be your emergency fund. Besides being financially risky, 401(k) loans can also shrink your future nest egg. Plus, if you lose your job, you may have to accelerate your loan payments. But if the only options you have for short-term financing are cripplingly high-interest credit cards and payday loans, then borrowing from your 401(k) may still be your best bet.