Loan secured by 401(k)

[Margaret CPA in OH]

Client took out $18,000 home improvement loan secured by 401(k). He says it was to remodel kitchen in house which is now a rental. I'm checking the timing of the loan and when he moved. Meanwhile, what happens with the interest paid on the loan? Is it paid into the plan and not deductible (whether for rental or home improvement or whatever purposes)? This is a first for me and I sort of thought that borrowing from your retirement wasn't a great idea except that it would possibly earn money at the interest level in place.

Thanks for guidance. I checked the IRS site on retirement plans, proceeds, etc. but couldn't find what I think I am looking for.

[Pacun]

The loan is not secured by the 401(k) otherwise it will be prohibited transaction. The loan comes out of the 401(k) and it is autolent to the owner of the 401(k).

This is the idea. On his left pocket he has the 401(k). On the other pocket, he has the rental property. His right pocket pays interest to his left pocket. Got the idea?

Ignore completely that a loan was made because it is a non-taxable and allowable transaction permited by the IRS and some 401(k) plans. Employers have the choice to get a 401(k) plan that will allow loans or not.

My 401(k) plans allows me to auto borrow 50% of my vested amount to a maximum of $50K. So, if I have $80K on my 401(k), I make a request on line and I am guaranted a loan for 40K with very low interest from my own money. My 401(k) investements will be reduced to 40K. As I pay my loan and interest back, my 401(k) grows from 40K. At the end, I will pay myself (maybe) 2K in interest which is placed in my 401(k) plan. No taxable event occurs, unless I default on my loan. Payments for my loan are automatically taken from my paycheck each pay period.

The loan is not conditioned to anything, so I can spend it whichever way I want. I don't have to give any explanation as to why I need the money.

[Margaret CPA in OH]

In general, I thought along the lines that you state. However, the IRS site states:

"Benefits must not be assigned or alienated. The plan must provide that its benefits cannot be assigned or alienated. A loan from the plan to a participant or beneficiary is not treated as an assignment or alienation if the loan is secured by the participant's account balance and is exempt from the tax on prohibited transactions under IRC 4975(d)(1) or would be exempt if the participant were a disqualified person. See Publication 560 for additional information on prohibited transactions. A loan is exempt from the tax on prohibited transactions under IRC section 4975(d)(i) if it:

Is available to all such participants or beneficiaries on a reasonably equivalent basis,

Is not made available to highly compensated employees (within the meaning of IRC section 414(q)) in an amount greater than the amount made available to other employees,

Is made in accordance with specific provisions regarding such loans set forth in the plan,

Bears a reasonable rate of interest, and

Is adequately secured."

So it says that there can be a loan to a participant secured by the participant's account balance. If the money is used in the rental property, though, why wouldn't the interest paid be deductible for the rental property purposes? If the money was borrowed from a bank and used for the rental, it would be deductible, right?

[Pacun]

The information you pasted relates to Fidelity or the company that offers 401k to employers. If the plan allows loans to be made, you don't have to worry because the plan is already established. If a violation occurs, the IRS will cancel the whole 401k for the company and maybe for all companies that have 401k with (let's say) Fidelity.

Remember the left and right pocket example. Your client is paying interest to himself. So, he cannot be deducted. If you insist, you can add the interest to line 8 of his 1040 and then deduct it on schedule E. The interest he is paying is not being paid to the bank or to company that holds the 401k.

Also, remember about related party transactions, most people are related to themselves. (That's a joke by the way) After a long day, we are not that funny anyways.

[Margaret CPA in OH]

Thanks again, Pacun. I am glad you brought up "bank", however. The form the client provided is from a local bank and the client wrote on it that it was a loan against his 401(k) savings. My question to him (not yet answered) was whether that bank has his 401(k) funds. Guess I need a bit more info from him.

I do appreciate the pocket example. That's why I originally asked the question. It didn't seem right, in one sense, to deduct interest paid to one's self. However, we do know that is the case when s-corp shareholders lend money to their company. The interest is deductible to the company and income to the s/h - legitimately, left and right pockets notwithstanding. More research needed for me on this one. Thanks again.

[Gail in Virginia]

I cannot provide a citation for my opinion, but I think the interest may be tax deductible. I know way back in the dark ages when I worked for a trust company in employee benefit plan administration, a lot of doctors borrowed their own funds from their 401(k) plan and deducted the interest. Normally, this would be income to the lender, but since the lender is the tax-deferred account, the interest is not taxed as interest but will be taxed when the funds are withdrawn as a distribution from the 401(k). Of course, if it is a Roth 401(k) and they meet the requirements, the interest earned on their account balance is never taxed. What a fun world taxation is!

[Margaret CPA in OH]

Thanks, Gail. I think what you wrote is more along the lines of my original thought process and I was just looking for some outside confirmation. In any event, I will still confirm from the client how the bank is involved and why the document is checked as unsecured.

[jasdlm]

Hi, Margaret. I think the 'hang-up' on deductible 401(k)/403( interest is whether the money you are borrowing is from employer contributions or employee deferrals. My understanding is that if the interest is on money borrowed from an employer's contributions(not employee deferrals) and used for an appropriate business/residence purpose, it is deductible, but if the interest is on money contributed by employee deferrals, it is not deductible. I think this would effectively rule out deductibility in most cases.

This is my understanding of IRC 72(p)(3); however, I have never worked with this in practice. Hopefully more experienced practitioners will weigh in.

[Margaret CPA in OH]

As it happens in this case, the client emailed earlier today that the loan was not from his 401(k). He said that the amount in it was only used to help determine his creditworthiness. That explains why the note states that the loan was unsecured. So we all got more education than we might have actually needed, at least for the moment.

Thanks to all for contributing!

[jasdlm]

I did NOT intentionally put in that little smiley faced dude with the sun glasses. Aaargh!

[Margaret CPA in OH]

But it is sooooo cute!

[Gail in Virginia]

That emoticon jumped in there when you tried to type the code section using the parentheses and the b. Unless you put an extra space in it like ( b ) it converts to ( and gives you the cute smiley face. Originally that is how emoticons were put in text ;)