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I have seen it commonly mentioned that 401K loans are offered commonly at Prime + 1% rates? But is that required by law? What section of the tax code addresses the upper and lowerbounds on interest rates in 401K loans?

Reason asking:

A company 401K might like to make a scheme of dropping interest rates for long term employees who have accumulated certain amounts of money in the account as a way to reward long term commitment/ease in case of emergency withdrawals.

On the opposite end, say in the personal example, you have an independent 401K and happen to be a pretty suave investor but need money immediately, and would like to pay yourself 7% for the year.

Both of these seem like valid instances to deviate from the standard Prime + 1% interest rate. Legally is there any thing stopping either scenario?

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The interest rate is determined by your 401(k) provider and your plan document. Of course you may be able to influence this, depending on your relationship with the provider. I'm very certain that prime+1% is not the only rate that is possible. However, your provider is constrained by IRC 4975(d), which states that the loan must be made "at a reasonable rate of interest."

The definition of "reasonable rate of interest" would probably need to go to court and I do not know if it has. The IRS probably has internal guidelines that determine who gets thrown to the dogs but they would not make those public because it takes away their discretion. Because of the threat of getting pounded by the IRS, I think you will have a hard time getting a provider to allow super high or super low interest rate loans.

Note: I am not a lawyer.

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  • That seems strange, why would they not want to be have a consistent law on the matter? Isn't that ripe for abuse/misapplication if the IRS can "throw to dogs" one client but inconsistently avoid doing to another?
    – Sidharth Ghoshal
    Commented Jul 24, 2017 at 5:28
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    Yes, I think it does allow that, which is one downside of our tax system. It's vague, complex, and sometimes contradictory enough that the IRS has a lot of latitude to do unfair things (and they do). Of course, if they do it to you, you can sue. Far be it from me to defend the IRS or tax code, but I suspect they believe having it vague causes people to cling to prime+1 out of fear, while having a clear set of guidelines would cause people to go immediately to the permitted extremes. Also remember, they don't make the laws, so there is a limit to how clear they can be.
    – farnsy
    Commented Jul 24, 2017 at 5:46
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    @frogeyedpeas, "reasonable" is determined by the facts and circumstances at the time, just like everything else. Historically, lending norms are not universal, it would be unreasonable for the IRS to set a universal standard for "reasonable." The rules are then enforced on a case by case basis, just like everything else. This is how all tax law is enforced in the US, you can lie on your return to your heats content, and it won't make one ounce of difference until you get caught, which might never happen.
    – quid
    Commented Jul 25, 2017 at 15:55
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    @frogeyedpeas For instance, if prime was 2%, "reasonable" might be 1.5% to 3%, whereas if prime were 10%, "reasonable" might be 8% to 15% (and several other factors might affect what is "reasonable"). Trying to pin down such variants with a hard set of rules would be both very difficult and inflexible.
    – TripeHound
    Commented Aug 23, 2017 at 6:55

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