What Is the Interest Rate to Borrow From 401k?

A 401(k) plan serves as a foundational component of many individuals’ retirement savings strategies, allowing for tax-advantaged growth over time. While primarily designed for long-term investment, these plans sometimes offer participants the option to borrow from their accumulated savings. This mechanism functions as a loan from your own retirement account, differing significantly from traditional loans obtained from external lenders. Understanding the specific terms and implications of such a loan is important for making informed financial decisions.

How 401(k) Loan Interest Works

The interest rate for a 401(k) loan is determined by the plan administrator, often set at the prevailing prime rate plus one or two percentage points. This rate is often competitive with, or lower than, rates for personal loans or credit card advances. A unique aspect of a 401(k) loan is that interest payments are directed back into your own 401(k) account, rather than to an external financial institution, meaning you are essentially paying interest to yourself. This can help replenish your retirement savings.

Beyond the interest, some 401(k) plans may charge administrative or origination fees for processing the loan. These fees are distinct from the interest and cover the costs associated with setting up and managing the loan. For instance, origination fees can range from $50 to $100, and maintenance fees might be $25 to $50. These administrative charges are a direct cost of borrowing that do not return to your retirement savings.

General Rules for 401(k) Loans

Not all 401(k) plans offer a loan feature, as it is an optional provision for employers to include. Eligibility to borrow depends entirely on the specific rules and terms outlined within your employer’s plan document. If a plan does permit loans, it must adhere to regulations set forth by the Internal Revenue Service (IRS).

IRS rules limit the maximum amount an individual can borrow to the lesser of $50,000 or 50% of their vested account balance. An exception allows for borrowing up to $10,000 if 50% of the vested account balance is less than this amount.

Repayment terms are also subject to specific guidelines. For general-purpose loans, the repayment period is limited to five years. If the loan is used for the purchase of a primary residence, the plan may allow for a longer repayment period, potentially up to 15 years or more. All loans require substantially equal payments that include both principal and interest, made at least quarterly. These payments are facilitated through automatic payroll deductions.

Repaying Your 401(k) Loan

Loan repayments are structured as automatic deductions from your paycheck. This method ensures that payments are made consistently and on time. The payroll deduction continues until the loan is fully satisfied, adhering to the predetermined amortization schedule.

If your employment ends, whether voluntarily or involuntarily, before the loan is fully repaid, the outstanding loan balance becomes due much sooner than the original repayment term. Many plans require full repayment within a short timeframe, often within 60 to 90 days following job separation. Failure to repay the outstanding balance by this accelerated deadline can lead to significant tax consequences.

If the loan is not repaid on time, the outstanding balance is treated as a taxable distribution from your 401(k) plan. This means the amount is subject to ordinary income tax. If you are under age 59½ at the time the loan is deemed a distribution, an additional 10% early withdrawal penalty may also apply. To avoid these tax implications, timely repayment is important. Recent tax law changes allow individuals who experience a loan offset due to job separation to roll over the amount into another eligible retirement plan, such as an IRA, by their tax return due date (including extensions) for the year of the offset, potentially avoiding immediate taxes and penalties.