Tax Consequences of Borrowing From a Retirement Plan

If your company has a qualified retirement plan or you have set one up in self-employment — such as a 401(k), profit-sharing, or Keogh plan — the participants might be allowed to borrow from their accounts. (This option is not available for traditional IRAs, Roth IRAs, SEPs, or SIMPLE-IRAs.)

In the right circumstances, taking out a plan loan can be a smart financial move because a participant gains access (within limits) to his or her retirement account money without having to pay taxes. Plus, when the loan is repaid with interest (which is generally at a reasonable rate), the participant is effectively paying the interest to him or herself rather than to some commercial lender. But there is a caveat: A participant must be prepared to pay back the borrowed money on time or face potentially dire tax consequences.

Here are some answers to frequently asked tax questions about retirement plan loans that you can pass along to your employees:

How much can I borrow?

The maximum you can borrow from a qualified retirement plan is generally:

• The lower of $50,000 or
• Half of your vested account balance.

Most plan loans are secured exclusively by the borrower’s vested account balance, although that’s not always the case.

What are the drawbacks?

There are two big ones:

Drawback No. 1 – Your account balance may be irreversibly diminished if you don’t pay the loan back. Why? Because the tax law imposes strict limits on how much can be contributed to an account each year. So you won’t necessarily be able to make up amounts by making bigger contributions later on.
Drawback No. 2 – If you fail to pay back the loan according to its terms, you face harsh tax consequences. Specifically, if you don’t repay it on time, the IRS considers you to have received a taxable distribution equal to the unpaid balance. That triggers a federal income tax liability and possibly a state income tax bill. To add insult to injury, if you’re under age 59 1/2, you may also get slammed with a 10% penalty tax.

Bottom Line: Failing to pay back a retirement plan loan is a financial sin for which you’ll pay dearly.

Can I deduct the interest?

It depends. With some exceptions, which we’ll explain later, the standard federal income tax rules for interest expense paid by individual taxpayers also apply to interest paid on a qualified retirement plan loan. Under these rules, your ability to deduct (or not deduct) the interest depends on how you use the borrowed money. In other words, you must trace where the loan proceeds go. Once the borrowed cash has been traced to a personal, business, or investment expenditure, the related interest expense is classified accordingly. Here are the deductibility rules:

• You cannot deduct personal interest unless you spend the borrowed money to acquire or improve your main or second residence or you spend it on qualified higher education expenses. However, in the case of interest on retirement plan loans used for educational expenses, the deduction is not available.
• If you inject the borrowed money into a pass-through entity business, such as an S corporation, partnership, or LLC, and you are active in the business, you can generally deduct the related interest as a business expense.
• If you invest the borrowed money, you can deduct the related interest to the extent of your investment income (from interest, short-term capital gains, and certain royalties).

These are the general rules and they are reasonably favorable.

Are there exceptions to these general rules for deducting interest?

Yes, and unfortunately, they are not so favorable. Specifically, you usually can’t deduct interest on 401(k) or 403(b) plan loans if any of the balance comes from elective deferrals. In other words, if it comes from salary reduction contributions that you’ve made.
Let’s say your plan loan is secured by your 401(k) or 403(b) account balance. If any of that balance is from your elective deferrals, you can’t deduct any of the interest. It doesn’t matter how you use the loan proceeds. It also doesn’t matter if there’s other security or collateral for your plan loan, such as your home. The fact is almost every 401(k) or 403(b) account balance includes at least some dollars from elective deferrals. Therefore, interest on loans from these types of plans is rarely deductible.

That said, you may be the exception. Your 401(k) or 403(b) account balance might have been funded exclusively by employer contributions and related earnings. Or your plan loan might be secured exclusively by the portion of your account balance attributable to employer contributions and related earnings and by another asset, such as your home. If you’re lucky enough to be in one of these rare categories, you can follow the general interest expense rules explained above, which means you might be entitled to a deduction for the interest on your 401(k) or 403(b) plan loan.

What about interest on other plan loans, such as a defined benefit plan? Is it deductible?

The chances are better. Let’s say you pay interest on a loan from a qualified retirement plan that’s not a 401(k) or 403(b) plan, such as a defined benefit pension plan or a garden-variety company profit-sharing plan. In most cases, the general interest expense rules for individual taxpayers explained above apply to you. Under those rules, you may or may not be able to deduct the interest, depending on how you spent the borrowed money.

However, there’s an exception. You cannot deduct any interest on a plan loan if you are a key employee of the employer that sponsors the retirement plan in question.

How do I know if I’m a key employee?

You are if any of the following three descriptions fits:
You’re an officer of the employer and receive annual compensation above $215,000 in 2023 (up from $200,000 in 2022).
You own more than five percent of the company that employs you. You must count both your direct ownership percentage, plus indirect ownership under the so-called attribution rules, which are complicated.
You own more than 1% of the company and receive annual compensation above $215,000 in 2023 ($200,000 in 2022). Once again, you must count your direct ownership percentage, plus indirect ownership under complicated attribution rules.

In Summary

If you borrow from your 401(k) or 403(b) plan, the resulting interest expense is very likely to be nondeductible — but not always. You could be one of the lucky few. Interest on loans from other types of plans may or may not be deductible under the general rules for interest expense paid by an individual, unless you’re an owner or high-powered employee (as defined by the tax law), in which case you can’t deduct any of your interest. As you can see, these rules are tricky. Consult with Kirsch CPA Group if you have questions or need more information.

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