If you’re considering taking out a 401k loan — borrowing from your 401k — then you’ve probably already heard that there’s interest involved in this loan. So what’s the deal with this 401k loan interest? Let’s take a look.
First of all, don’t take borrowing against your 401k lightly. Yes, it’s your money and you’ve already earned it, but you should not think of your 401k the same way that you think of your savings account. First of all, this is the retirement income you’re talking about. If you mess it up, nobody’s going to fix it for you, and you won’t have enough time to refill it through more hard work. You only get one life and one retirement. Make sure you’re thinking carefully about the risks. By the way, if you aren’t able to pay it back in full or on-time, you’ll end up having to pay state and federal taxes on whatever you took out (now it’s income!) and you’ll also end up owing the IRS an extra 10% of whatever you withdrew as a penalty for early withdrawal.
Now that I’ve properly battered you with the risks of early withdrawal, let’s get into the interesting part. (The interest, get it?)
Who Earns the Interest on a 401k Loan?
Interestingly, you do. That’s right, the interest you pay toward your 401k loan as you pay it back goes right into your 401k. So why is there interest on this loan in the first place? It’s basically to discourage people from taking the decision too lightly. (See above for another round of caution.) Borrowing from your 401k means getting access to tax-free money. If there weren’t an interest rate on it, you might find the prospect of borrowing it too enticing — at least this seems to be the fear of the Federal Government. But you’re smarter than that, right?
In case you aren’t there is something to be concerned about when it comes to losing your interest payments.
Is 401k Loan Interest Taxed Twice?
Some financial pundits out there have posited that borrowing from your 401k twice is a bad idea because you “pay interest on that money twice!” While there are plenty of reasons to think carefully before borrowing from your retirement savings (Again, go back to the first paragraph), this is not one of them. That’s because repaying your 401k loan involves using post-tax money to replace pre-tax money. But this is true of any loan. A car loan. A home loan. Typically, no money you borrow requires you to pay taxes on that money.
However, the interest you pay on your 401k does get taxed twice, interestingly. That’s because it’s money you’re putting into your 401k from the post-tax income that you did not borrow. So you put taxed interest into the account, then, when you withdraw your 401k, you are taxed on every penny you withdraw. So how much money will you be paying taxes on twice when you borrow from your 401k? I’m glad you asked.
How Much Interest Do I have to Pay on my 401k Loan?
This answer is a bit more nebulous, unfortunately. The exact answer is “it depends.” Typically, a 401k interest rate will be about the same as the Prime Rate, plus 1 or 2 percent. That prime rate is calculated daily by The Wall Street Journal based on an average of the lending rates of 30 major financial institutions. At the time of this writing, it was 3.25%, and it hasn’t changed in over a year. So the interest rate on a 401k loan could be as much as roughly 5%, which is still pretty low compared to most loans you might take out.
Everyone’s retirement outlook and the personal scenario is different. That’s why there are professional financial advisers and retirement specialists in your area waiting to help you. There’s a whole profession just for this need. If you are considering a 401k loan, speak with one of these professionals one-on-one, lest you end up eating cat food in a cold basement for the last 20 years of your life. Worse things have happened to people who acted frivolously with their retirement savings. Take caution. And if you need a reminder of the things you should be concerned with, scroll up and read the first part of this blog post one more time.