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).

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 account, it feels like you’re paying yourself. Sounds great—until you dig into the tax implications.

The reality of double taxation

The interest you pay on a 401(k) loan gets taxed twice because of how the repayment process interacts with the tax rules for retirement accounts. Here is how it plays out for both types of accounts:

• Traditional 401(k): In a traditional 401(k), your contributions are made with pre-tax dollars. When you take a loan, you must repay the interest with after-tax dollars—money from your paycheck that has already been taxed. When you withdraw that same interest money in retirement, it is taxed again as ordinary income. You pay tax on the interest when you earn the money to repay it, and you pay tax on it again when you take it out later.
• Roth 401(k): In a Roth 401(k), you contribute after-tax dollars, and qualified withdrawals are tax-free. However, the interest you pay on a loan still inflicts a tax penalty. You must use after-tax dollars to cover the interest, meaning you pay tax on those earnings without receiving the upfront tax break that makes Roth accounts attractive. You effectively pay tax on the interest money without getting any unique Roth benefit for that specific payment.

A real-world example

Imagine you take a $20,000 loan and pay $2,000 in interest over five years. If you are in a 25% tax bracket, the math highlights the true cost:

• Upfront tax cost: For both types of accounts, you need to earn $2,667 in pre-tax income to cover the $2,000 interest payment, because $667 goes to taxes right away.
• Retirement tax cost: With a traditional 401(k), that $2,000 is taxed again at withdrawal, costing you another 25% (or $500). This brings your total tax paid on the interest to $1,167.
• Roth alternative: With a Roth 401(k), you avoid the second tax if the withdrawal is qualified, but you still lose the $667 in initial taxes to pay the interest.

Hidden risks of 401(k) loans

Double taxation adds up over time, reducing the true value of the money going back into your account. Beyond taxes, 401(k) loans come with other serious risks:

• Lost growth: The money you borrow is removed from the market, so you miss out on compounding interest and potential market gains.
• Repayment pressure: If you leave your job, you may need to repay the loan balance in full within a short period, often 60 days. If you cannot, it is treated as a taxable withdrawal and hit with a 10% penalty if you are under 59.
• Opportunity cost: The funds used to service the loan debt could have gone toward other financial goals, like building an emergency fund or making new retirement contributions.

Should you avoid 401(k) loans?

Not necessarily, but they should not be your first choice. Before borrowing from your retirement plan, consider these alternatives:

• Emergency savings: Use a rainy-day fund instead of tapping retirement savings.
• Personal loans: Compare bank rates, as a standard personal loan will not trigger retirement double-taxation or job-contingent repayment.
• Cutting expenses: Look for immediate ways to free up cash in your budget.

If a 401(k) loan is your only option for a critical need, make sure you go in with your eyes wide open to the true lifetime costs.