Where Does 401(k) Loan Interest Go?
Many don’t know the interest you pay on a 401(k) loan goes back into your 401(k) account. However, it may end up costing you more down the line.
Tapping into your 401(k) through a 401(k) loan can be a great way of accessing your retirement funds while avoiding costly taxes and penalties. When faced with a significant emergency or repair, the funds from your 401(k) can be a lifesaver. However, there are many stipulations that make taking out a 401(k) loan worth giving a second thought. Most important is what may happen if you lose your job with an outstanding 401(k) loan, but also the interest you’ll pay should be considered.
When you repay your 401(k), you’ll pay back the principal amount as well as interest. But where does the 401(k) loan interest go? Fortunately, when you repay your 401(k) loan, the interest goes back into your 401(k) account. Rather than being lost to a bank, you keep the interest you pay on your 401(k) loan to build until you retire.
Before you go and apply for a 401(k) loan from your plan’s administrator, it’s essential to know the basics of 401(k) loans. Additionally, make sure you understand how the interest works.
How do 401(k) loans work?
401(k) loans are meant to be an option to provide temporary access to 401(k) accounts. Rather than taking withdrawals from a 401(k), which incur taxes and penalties, borrowers must repay 401(k) loans to avoid any such financial ramifications.
The IRS limits 401(k) loans to $50,000 or 50% of the 401(k) balance, whichever is less. If what you need a loan for is larger than 50% of your 401(k), consider rolling over your old 401(k)s to your current one. This will increase your 401(k) balance, thus increasing the amount of your 401(k) loan.
The IRS also sets the repayment length. Typically, 401(k) loans must be repaid within five years; however, due to COVID legislation, an extra year has been added to outstanding 401(k) loans. 401(k) loans that have been taken out to purchase a home have an extended repayment period of 15 years.
To apply for a 401(k) loan, you’ll need to contact your 401(k) plan’s administrator or go through their online portal. Either way, you will be asked to provide information and choose whether you’d like your loan funds sent via check or direct deposit. Direct deposit is much faster, although each option will take between one to four weeks from application to receipt of the funds.
You will be required to pay the loan’s principal amount and interest to keep the loan current. Fortunately, both principal and interest payments go directly back into your 401(k) account. This helps bring your 401(k) back up to the amount it was before you took the loan out. The interest also helps make up for the lost compounding interest your 401(k) would have received in the meantime.
Additionally, your 401(k) plan’s administrator will charge origination or administration fees for processing your loan for you. This money goes towards the plan’s administrator; however, these fees are usually modest.
If you leave your job or get fired with an outstanding 401(k) loan, you’ll need to repay the remaining balance within 60 days.
How are 401(k) loan interest rates calculated?
Although your 401(k) administrator is facilitating your 401(k) loan and not a bank, there is a method in deciding what interest rate you’ll pay on your loan. While the interest you pay on your 401(k) goes back into your 401(k) account, your plan’s administrator will set your rate for you.
Typically, the interest rate on a 401(k) loan is between one and two percent higher than the prime interest rate. The prime interest rate is set by the Wall Street Journal and calculated daily based on a survey of 30 banks’ lending rates.
The interest rate on your 401(k) loan will depend on the prime interest for the day your loan application is submitted.
Who gets to keep the 401(k) loan interest?
You do. Well, the future you gets to keep the interest you pay on your 401(k) loan.
While the IRS sets the loan limits, repayment terms, and other rules, and your plan’s administrator sets your interest rate; you get to keep your principal and interest payments.
Aside from any origination or administrative fees, every dollar you repay towards your 401(k) loan goes back into your 401(k) loan. This helps you replenish the amount you took out for the loan, as well as adds some back that your 401(k) would’ve received in compounding interest had you left the money in there.
The negative to paying 401(k) loan interest back to yourself.
While keeping the interest you pay is a nice perk, it’s not entirely a no-lose deal.
You see, when you make payments towards your 401(k) loan, you do so with after-tax money. This, in essence, eliminates the tax-deferred benefits of your 401(k).
Because you’re repaying your 401(k) loan with after-tax money, you’re paying taxes before you put money back into your 401(k) account. However, when you take that money out during retirement, you’ll be taxed on that money again. This creates a double taxation effect on the money you put into your 401(k).
So while tapping into your 401(k) via a 401(k) loan may get you out of a jam now, it can have costly effects down the road. If possible, consider other lending options and leave your 401(k) to grow over time; your future self will thank you.