Should You Borrow From Your 401(k) to Exercise Options?

So you’re sitting on vested options in a late-stage private startup. Maybe your company’s IPO buzz is heating up. Maybe a secondary window is finally opening. Maybe you’re wondering where to get cash to exercise. You may want to consider using your 401(k). But is it a good idea?

Yes, with caveats. A 401(k) loan might offer the upfront cash you need without triggering taxes or penalties up front. But borrowing from your retirement account is a move you’ll want to make once you consider the trade-offs.

Here’s what you need to know about 401(k) loans, how they compare to 401(k) withdrawals, and whether they’re a smart way to fund your next move.

First, what’s the difference between a 401(k) loan and a 401(k) withdrawal?

A 401(k) loan lets you borrow against your retirement savings and pay yourself back, with interest. The money isn’t taxed when you take it out, and the interest you pay goes right back into your account. It’s not “free money,” but it’s not lost either.

A 401(k) withdrawal, on the other hand, is a permanent removal of funds. You'll owe income tax on the amount you withdraw, plus a 10% early withdrawal penalty if you're under age 59½ (unless you qualify for a hardship exemption). There’s no repayment required, but there’s also no putting the money back.

Loans are temporary. Withdrawals are forever. If you're exercising options, a loan against your 401(k) is almost always the lesser evil if you can repay on schedule.

How much can you borrow?

The IRS and your plan both set limits. Here’s what most plans allow:

• You can borrow up to 50% of your vested account balance or $50,000, whichever is less.
• If 50% of your balance is less than $10,000, some plans allow you to borrow up to $10,000 minimum.
• Repayment is typically required within 5 years.
• You may be limited to one or two loans at a time, depending on plan rules.
• You may also need spousal consent to take out a loan if your plan is subject to the qualified-annuity spousal-protection rules.

These limits are set by federal 401(k) loan rules, but always check your plan's specifics before making a move. 

Prospect can model the ROI of exercising your options—taxes, timing, and take-home included.

What’s the 401(k) loan interest rate?

There’s no universal number here; it’s set by your employer’s plan. The “prime rate” is a benchmark rate that large banks charge their most credit-worthy customers and that many other rates track closely. Common plans may set the prime rate plus 1 % or 2 %. Make sure to check your plan document for the real numbers.

The good news? That interest isn’t going to a bank. It’s going back into your retirement account. You’re essentially paying yourself to borrow your own money.

Pros of using a 401(k) loan

Let’s talk benefits—because if you're considering using a 401(k) loan to exercise stock options, there are real upsides.

• No taxes or penalties up front. This is a major difference from a withdrawal. If you follow the loan rules, you keep the IRS out of the picture.
• No credit check. This is your money. You don’t need to apply or qualify the way you would for a personal loan.
• You repay yourself. Every dollar of interest goes back into your retirement, not to a lender.
• Doesn’t affect your credit score. Even if you default, it's not reported to credit bureaus.

If you're betting on a liquidity event, a 401(k) loan could offer a fast, tax-efficient bridge to exercise and hold.

Cons and caveats

Of course, there's no such thing as a free lunch. Here are the tradeoffs:

• You’re using after-tax dollars to repay the loan, and the interest-portion of the repayment will be taxed again when you eventually withdraw them in retirement (though not the principal). That’s a hidden cost.
• You could miss out on market gains. While your borrowed funds are out of the market, they’re not compounding. That opportunity cost adds up, especially if the market outpaces your loan interest rate.
• If you leave your job, the loan is due fast. You’ll typically have to repay the balance in full by tax day of the following year. If you can’t, the outstanding balance becomes a taxable distribution—plus that 10% penalty if you’re under 59½. However, you can avoid the tax hit by rolling the outstanding balance into an IRA or another qualified plan by your tax-return deadline, effectively treating it as a rollover instead.
• You might not be able to borrow more later. Some plans limit you to one or two loans at a time. If you use your only loan now, it may limit your flexibility down the road.

Using a 401(k) loan to exercise options is a strategic risk. If your company hits, you win. If not, you’ve compromised your retirement savings for a stake in a company that didn’t pay off.

What about a 401(k) withdrawal?

It’s usually not recommended, but here’s what it looks like.

Pros:

• You don’t have to repay the funds.
• No loan interest or repayment schedule.

Cons:

• You’ll owe income taxes on the full amount.
• You’ll likely get hit with a 10% early withdrawal penalty.
• You shrink your retirement savings.
• You lose out on potential compound growth for decades.

Exercising stock options doesn’t count as a hardship under IRS rules.

So, unless you're over 59½ or have no other options, stick with the loan.

Should you use a 401(k) loan to exercise options?

Here’s the quick decision framework:

• You believe your company will IPO, have a tender offer, or get acquired in the next 12–24 months

• You’ve run the tax models and believe there is a positive ROI (hello, AMT)

• You’ve maxed out more liquid sources of capital

• You understand the risks, and you're still in

Then yes, a 401(k) loan might make sense.

But if you're not sure about repayment timelines, market upside, or the strength of your company’s exit plan? You might want to think twice. Plus, if the spread falls after exercise, you could will have paid taxes on money you never actually pocket. 

Can you still contribute while repaying a 401(k) loan?

Yes. It can be tempting to reduce or pause your contributions, but you may want to continue them.

Why it matters: Skipping 401(k) contributions while you repay your loan compounds the cost, literally. You lose out on employer matching, market gains, and years of tax-deferred growth.

If you’re taking a 401(k) loan to fund your startup equity play, great. But don’t stop investing in your future while you do it.

What are the alternatives?

Before you pull the trigger on a loan against your 401(k), ask: Is there a better path?

• Roth IRA contributions (not earnings) can be withdrawn tax and penalty-free.
• Brokerage accounts give you more liquidity without touching retirement assets (though you need to sell what you hold in your brokerage account)
• Personal loans may offer comparable costs depending on the interest rates
• Home equity lines of credit may offer lower interest rates if you’re a homeowner.

You’ve got options. Don’t default to tapping your retirement plan just because it’s there.

What to do next

• Review your plan's loan terms via your provider dashboard
• Confirm your vesting balance and the eligible loan amount
• Compare the 401(k) loan interest rate to other available financing options
• Run scenario models in Prospect, including what happens if you switch jobs
• Make a plan to keep contributing during repayment

If you want to take the guesswork out of tax planning and timing, that’s where we come in.

Prospect helps startup employees make smarter decisions about equity, from modeling your ideal option strategy to planning exercises that won’t derail your retirement.

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