How Much Is Interest on a 401(k) Loan?
Understand the unique financial structure of 401(k) loans, including how interest works and its broader impact on your retirement savings.
A 401(k) loan provides a way for individuals to access funds from their retirement savings before traditional retirement age. Unlike typical loans from external lenders, a 401(k) loan involves borrowing from oneself, with the borrowed amount and interest being repaid directly back into the participant’s retirement account.
How 401(k) Loan Interest is Determined
The interest rate for a 401(k) loan is typically established by the specific 401(k) plan administrator, rather than being subject to market rates from commercial lenders. This rate is commonly set at the prime rate plus one or two percentage points, and it usually remains fixed for the entire duration of the loan. For instance, if the prime rate is 8%, the loan interest rate might be 9% or 10%. This fixed rate predictability helps borrowers understand their total repayment obligation over time.
The interest paid does not go to an external financial institution or the plan sponsor. Instead, all interest payments are credited back into the participant’s own 401(k) account. This means the interest contributes to the growth of the individual’s retirement savings, distinguishing it from traditional loans where interest is a cost paid to a third party. The specific interest rate and calculation methodology are detailed in the individual 401(k) plan’s loan policy.
Beyond Interest: Other Costs and Repayment Details
Other costs can be associated with a 401(k) loan. These may include an initial loan origination fee, often ranging from $50 to $100, and potential annual loan maintenance fees, which can be around $25 to $50. These administrative charges can reduce the net amount a borrower receives or increase the overall cost of the loan.
Most loans must be repaid within a period of five years, although loans taken for the purchase of a primary residence may qualify for a longer repayment term, potentially up to 10 or 15 years, depending on the plan. Payments are typically made through automatic payroll deductions, which helps maintain a regular repayment schedule and reduces the risk of missed payments.
Federal regulations also set limits on the amount that can be borrowed from a 401(k) account. Generally, a participant can borrow the lesser of $50,000 or 50% of their vested account balance. These limits ensure that a substantial portion of the retirement savings remains invested.
Tax Considerations for 401(k) Loans
The tax treatment of 401(k) loans differs from many other loan types. The interest paid on a 401(k) loan is generally not tax-deductible, unlike interest paid on certain other loans such as qualified home mortgages. This means borrowers cannot claim a tax deduction for the interest portion of their repayments.
All repayments, including both principal and interest, are made with after-tax dollars. Since the funds are deposited back into a tax-deferred account, they will be taxed again upon withdrawal in retirement. This can lead to a form of “double taxation” on the interest component, as those dollars are taxed when earned, repaid to the account, and then taxed again as a distribution in retirement.
Failing to repay a 401(k) loan can trigger significant tax consequences. If the loan is not repaid, the outstanding balance can be considered a “deemed distribution” from the plan. This deemed distribution becomes taxable income in the year of default. Furthermore, if the participant is under age 59½ at the time of default, the deemed distribution may also be subject to an additional 10% early withdrawal penalty, as outlined in Internal Revenue Code Section 72.