The interest on a 401(k) loan goes back into your own retirement account. You are both the borrower and the lender, so every dollar of interest you pay is deposited into your 401(k) balance alongside your principal repayments. No bank, plan administrator, or outside lender takes a cut. That sounds like a clean deal, and in one sense it is, but the way those interest dollars are taxed and the risk of default create real costs that the “paying yourself” framing hides.
Where Your Interest Payments Actually Land
When you take a 401(k) loan, the plan sells a portion of your investments and hands you the cash. Your repayments, both principal and interest, flow back into your account and get reinvested according to your current allocation. The IRS requires that all loan repayments go back to the borrower’s retirement account under the plan.1Internal Revenue Service. Hardships, Early Withdrawals and Loans
The interest effectively replaces some of the investment growth your account missed while the borrowed money sat outside the market. Whether that trade works in your favor depends on what the market does. In a strong market year, the growth you missed on the borrowed amount could easily exceed what you paid yourself in interest. In a flat or declining year, the fixed interest you paid in may beat what those dollars would have earned invested.
How the Rate Gets Set
Federal law does not fix a specific interest rate for 401(k) loans. ERISA and the Internal Revenue Code require only that plan loans carry a “reasonable rate of interest,”2Office of the Law Revision Counsel. 29 U.S. Code 1108 – Exemptions From Prohibited Transactions and that the loan be adequately secured, which your vested account balance handles as collateral.3Office of the Law Revision Counsel. 26 U.S. Code 4975 – Tax on Prohibited Transactions Treasury regulations list the factors administrators weigh: loan amount and duration, security, borrower credit standing, and prevailing rates for comparable loans.4Internal Revenue Service, Treasury. 26 CFR 54.4975-7 Other Statutory Exemptions
In practice, most plans use a simple formula: the prime rate plus one or two percentage points. With the prime rate at 6.75% in late 2025, a typical 401(k) loan rate falls somewhere between roughly 7.75% and 8.75%. Your plan document states the exact formula.
Why Paying Yourself Interest Still Costs You
Here is the part that trips people up. The interest returns to your account, yes. But you paid it in with after-tax dollars from your paycheck, and if you have a traditional 401(k), you will pay tax on those same dollars again when you withdraw them in retirement.
Every loan repayment, principal and interest alike, comes out of pay that federal and state income taxes have already touched. Those after-tax dollars land in your traditional 401(k) and mix with your original pre-tax contributions. When you take distributions in retirement, the IRS treats the entire withdrawal as ordinary income.5Internal Revenue Service. Considering a Loan From Your 401(k) Plan The account does not track which dollars were pre-tax and which were after-tax. The interest gets taxed twice.
A concrete example. Say you pay $2,000 in interest over the life of a loan, and you are in the 22% tax bracket both now and in retirement. You paid about $440 in income tax to earn that $2,000 in the first place. You will pay roughly another $440 when it comes back out. That is about $880 in total tax on $2,000 of interest you paid to yourself.
If your plan offers a Roth 401(k) and your loan is repaid into a Roth account, qualified distributions come out tax-free, which avoids the second layer. Most plans, though, route loan repayments back into the same account type the money came from.
What the Interest Doesn’t Cover
Interest returns to your account. Fees do not. Plan providers typically charge a one-time origination fee, often somewhere between $50 and $150, deducted from your loan proceeds or your balance before the money reaches you. Many plans also charge an annual maintenance fee in the $25 to $50 range while the loan is outstanding. Those dollars go to the plan’s service provider for recordkeeping and processing. They leave your retirement savings and do not come back.
Your Summary Plan Description spells out the fee schedule. Reading it before you borrow lets you calculate the real cost: interest rate, origination fee, ongoing charges, and the investment growth you will miss while the balance is out of the market.
When Paying Yourself Interest Turns Into a Tax Bill
An outstanding 401(k) loan gets much more expensive if you leave your job or default. Most plans demand full repayment shortly after separation, often within 60 to 90 days, depending on the plan’s terms. If you cannot repay the balance, the plan treats it as a distribution.
Two costs follow. The unpaid amount is added to your gross income for the year. And if you are under 59½, the IRS charges an additional 10% early distribution penalty on the taxable portion.6Internal Revenue Service. 401(k) Resource Guide Plan Participants General Distribution Rules One exception to the penalty: if you separated from the employer during or after the calendar year you turned 55, it does not apply. The plan reports a defaulted loan to the IRS on Form 1099-R with distribution Code L, flagging it as a deemed distribution under the loan rules.7Internal Revenue Service. 2025 Instructions for Forms 1099-R and 5498
If the loan is offset because you separated from the employer, the unpaid balance is a Qualified Plan Loan Offset, and you can avoid the tax hit by rolling that amount into an IRA or another eligible retirement plan by your tax-filing deadline for the year of the offset, including extensions.8Internal Revenue Service. Plan Loan Offsets That window buys you time to find the cash, but it requires action on your part. Miss it, and the interest you diligently paid to yourself gets buried under a tax bill on the whole outstanding balance.