401(k) loans: Why interest gets taxed twice

Borrowing from your 401(k) might seem like a quick fix when you’re in a financial pinch. After all, you’re borrowing from yourself, and the interest you pay goes back into your own account—win-win, right? Not so fast. There’s a catch that many people overlook: the interest you pay on a 401(k) loan can be double taxed, and this applies whether you have a traditional 401(k) or a Roth 401(k). Let’s break down why this happens, how it works for both types of accounts, and what you should consider before taking out a 401(k) loan.

What is a 401(k) loan?

A 401(k) loan lets you borrow money from your retirement account, depending on your employer’s plan, typically up to $50,000 or 50% of your vested balance, whichever is less. You repay the loan (plus interest) over a set period, often five years, through payroll deductions. The interest rate is usually low, and since the interest goes back into your 401(k), it feels like you’re paying yourself. Sounds great—until you dig into the tax implications.

Double taxation

Here’s the crux of the issue: the interest you pay on a 401(k) loan gets taxed twice. This happens because of how the repayment process interacts with the tax rules for retirement accounts. Let’s look at how this plays out for both traditional and Roth 401(k)s.

Traditional 401(k): A clear double hit

In a traditional 401(k), your contributions are made with pre-tax dollars, meaning you haven’t paid income tax on that money yet. When you take a loan, you repay both the principal (the amount you borrowed) and the interest with after-tax dollars—money from your paycheck that’s already been taxed.

For example, let’s say you borrow $10,000 and pay $1,000 in interest over the life of the loan. To come up with that $1,000, you might need to earn about $1,333 if you’re in a 25% tax bracket (since $333 goes to taxes). That $1,000 in interest goes back into your 401(k), but here’s the kicker: when you withdraw that money in retirement, it’s taxed again as ordinary income. So, you pay tax on the interest when you earn the money to repay it and when you take it out later. That’s double taxation, and it quietly chips away at your savings.

Roth 401(k): A subtler sting

In a Roth 401(k), you contribute after-tax dollars, so you’ve already paid tax on the money you put in. Loan repayments, including interest, are also made with after-tax dollars. At first glance, you might think the interest escapes double taxation since qualified Roth withdrawals (after age 59? and a 5-year holding period) are tax-free. But here’s where it gets tricky.

The interest you pay doesn’t get the same tax advantage as your original Roth contributions. You’re still using after-tax dollars to cover the interest—dollars you paid tax on to earn—without any special tax break for those payments. In our $10,000 loan example, the $1,000 in interest still costs you $1,333 in pre-tax earnings (assuming a 25% tax bracket). Even though that $1,000 might come out tax-free in retirement, you’ve effectively paid tax on it without the upfront tax benefit that makes Roth accounts so attractive. It’s a subtler form of double taxation, but it’s still a cost you can’t ignore.

Why does this matter?

Double taxation might not sound like a big deal if the interest payments are small, but it adds up over time. That extra tax hit reduces the true value of the money going back into your account. Plus, 401(k) loans come with other risks:

• Lost growth: The money you borrow isn’t invested, so you miss out on potential market gains.
• Repayment pressure: If you leave your job, you may need to repay the loan in full within a short period (often 60 days), or it’s treated as a taxable withdrawal with penalties if you’re under 59 1/2?
• Opportunity cost: The money used to repay the loan could have gone toward other financial goals, like building an emergency fund.

A real world example

Let’s make this concrete. Imagine you take a $20,000 loan from your traditional 401(k) and pay $2,000 in interest over five years. If you’re in a 25% tax bracket:

• You need to earn $2,667 to cover the $2,000 interest ($667 goes to taxes).
• That $2,000 goes into your 401(k), but when you withdraw it in retirement, it’s taxed again—say, another 25%, or $500.
• Total tax paid on the interest: $667 (when earned) + $500 (when withdrawn) = $1,167.

In a Roth 401(k), you’d still pay the $667 in taxes to earn the $2,000, but you might avoid the second tax if the withdrawal is qualified. Either way, the interest payments cost you more than they seem.

So, should you avoid 401(k) loans?

Not necessarily—but perhaps they shouldn’t be your first choice. Before borrowing from your 401(k), consider alternatives:

• Emergency savings: If you have a rainy-day fund, use it instead of tapping retirement savings.
• Personal loans: Compare the interest rate and terms. A bank loan might be cheaper overall, especially without the double-tax hit.
• Cutting expenses: Look for ways to free up cash.