Able to deduct 401K loan interest?

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Able to deduct 401K loan interest?

Postby Sammy_M » Sun Feb 05, 2012 2:30 pm

I took a 401K loan to finance the purchase of a rental property. Can I deduct the interest I am paying to the 401K account on Schedule E? I will have to pay taxes on that interest when I withdraw the money from the 401K. Is the 401K loan a true debtor-creditor relationship in the eyes of the IRS? Is it "personal interest"?

Publication 535, Chapter 4 wrote:Interest You Can Deduct

You can generally deduct as a business expense all interest you pay or accrue during the tax year on debts related to your trade or business. Interest relates to your trade or business if you use the proceeds of the loan for a trade or business expense. It does not matter what type of property secures the loan. You can deduct interest on a debt only if you meet all the following requirements.

You are legally liable for that debt.

Both you and the lender intend that the debt be repaid.

You and the lender have a true debtor-creditor relationship


Interest You Cannot Deduct

Certain interest payments cannot be deducted. In addition, certain other expenses that may seem to be interest are not, and you cannot deduct them as interest.

You cannot currently deduct interest that must be capitalized, and you generally cannot deduct personal interest.


http://www.irs.gov/publications/p535/index.html
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Re: Able to deduct 401K loan interest?

Postby archbish99 » Sun Feb 05, 2012 2:41 pm

Nope -- sorry. Don't have a reference, but I'm pretty sure it's not permitted.
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Re: Able to deduct 401K loan interest?

Postby Sammy_M » Sun Feb 05, 2012 2:46 pm

Yep, the answer is no. Here is more on the topic.

Interest paid on a loan secured by the participant's (borrower's) 401(k) or 403(b) account is
nondeductible if any of the account balance used to secure the loan is
attributable to elective deferrals (i.e., elective salary reduction
contributions the employee signed up for). This is true regardless of how
the loan proceeds are used and regardless of the existence of other
security for the loan, such as the participant's home.

source
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Re: Able to deduct 401K loan interest?

Postby pkcrafter » Sun Feb 05, 2012 2:54 pm

I think the interest paid on a 401k loan goes back into your own 401k account. If we could take a loan, pay ourselves back, and deduct the interest, it would be a good thing. :)

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Re: Able to deduct 401K loan interest?

Postby xerty24 » Sun Feb 05, 2012 2:58 pm

Sammy_M wrote:I took a 401K loan to finance the purchase of a rental property. Can I deduct the interest I am paying to the 401K account on Schedule E? l

Not if you borrow from elective deferrals

http://voices.yahoo.com/what-tax-conseq ... 56717.html
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Re: Able to deduct 401K loan interest?

Postby Alan S. » Sun Feb 05, 2012 8:58 pm

This is one of the reasons that the interest payments on the loan (but not the principal) are double taxed. If you could deduct the interest you are repaying to the plan, it would eliminate double taxation of that interest, ie. you are repaying from after tax salary yet the interest being repayed does not get any basis in the plan and becomes taxable upon eventual distribution. But the interest is not deductible per Sec 72(p)3 of the tax code.
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Re: Able to deduct 401K loan interest?

Postby archbish99 » Mon Feb 06, 2012 11:07 am

Alan S. wrote:This is one of the reasons that the interest payments on the loan (but not the principal) are double taxed. If you could deduct the interest you are repaying to the plan, it would eliminate double taxation of that interest, ie. you are repaying from after tax salary yet the interest being repayed does not get any basis in the plan and becomes taxable upon eventual distribution. But the interest is not deductible per Sec 72(p)3 of the tax code.

OP, just so you know, it's no more double-taxed than if you took out a personal loan from someone else. The interest is taxable to the lender, and the money you would pay it with has already been taxed in either case. It just so happens that in this case the lender who owes taxes on the interest is future-you, and the loan is an interest-accruing bond held as an investment in your tax-deferred account. There are several threads debating whether this is actually "double-taxation."
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Re: Able to deduct 401K loan interest?

Postby KSActuary » Mon Feb 06, 2012 12:05 pm

All I know is that now someone has a tax preferenced account with after-tax money in it that will be taxed again. Whether or not the reason for the loan was legitimate can be discussed but the asset purchased with the loan is usually long gone at retirement.
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Re: Able to deduct 401K loan interest?

Postby xerty24 » Mon Feb 06, 2012 12:15 pm

I find thinking through these "double taxed" discussions a lot easier if you start by thinking about the case where your Roth 401k makes the loan.
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Re: Able to deduct 401K loan interest?

Postby Sammy_M » Mon Feb 06, 2012 2:19 pm

Like most everything, it is an issue of perspective.

I recognize that the interest that I'm repaying to my 401K with after tax dollars is going to be taxed again when I withdraw. From that standpoint, it is double taxed, but who cares if it is my least expensive form of financing.

I have a stable value fund that I would be invested in had I not taken the loan. Let's say it yields 3%, which is probably generous.

The interest on the 401K loan is 4%. Assuming a marginal tax rate in retirement of 25%, the actual cost to me (in the form of taxes) is 1%.

1%, plus the lost return on the stable value of 3%, yields a total of 4%.

I can't get a 4% loan for a rental property elsewhere. Job is very stable, plus I've got funds to repay the loan if necessary. It's an easy decision.
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Re: Able to deduct 401K loan interest?

Postby Sam I Am » Sat Mar 16, 2013 11:03 am

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Re: Able to deduct 401K loan interest?

Postby Gill » Sat Mar 16, 2013 11:06 am

Sam I Am wrote:Am I remembering correctly, wasn't it possible at one time to deduct the interest paid on 401k loans?

I thought I had the ability to do that, until some loopholes were plugged.

Sam I Am

Yes, once upon a time you could deduct all interest and most taxes. No more.
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Re: Able to deduct 401K loan interest?

Postby Sam I Am » Sat Mar 16, 2013 11:27 am

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Re: Able to deduct 401K loan interest?

Postby ofckrupke » Wed Mar 27, 2013 8:05 pm

Alan S. wrote:This is one of the reasons that the interest payments on the loan (but not the principal) are double taxed. If you could deduct the interest you are repaying to the plan, it would eliminate double taxation of that interest, ie. you are repaying from after tax salary yet the interest being repayed does not get any basis in the plan and becomes taxable upon eventual distribution. But the interest is not deductible per Sec 72(p)3 of the tax code.


From a quick reading of 72(p) it seems as though interest paid on a loan from a 401(a) plan of non-elective contributions, having a compliant repayment schedule, ought to be deductible for the year(s) paid. Am I missing something, or can such 401(a) loans escape the effective double taxation of interest?

BTW: in the text of 72(p) what is meant by "level amortization"? Does it mean level repayment of principal (and thus gradually decreasing periodic payments as the interest component decreases), xor level-payment amortization - as found in a fixed rate mortgage?
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Re: Able to deduct 401K loan interest?

Postby Alan S. » Thu Mar 28, 2013 4:19 pm

If the loan is not funded with elective deferrals as defined and the exclusion of 72(p)(3) is not applicable, it becomes eligible for deduction. Of course, that brings into play the use of the funds, Sch A exceeding the standard deduction, investment interest limitation to investment income, and for mortage interest, the loan must be secured. It is unlikely that the plan will be willing to secure the loan with the property when they already have the plan balance as security. If all these things fall into place, double taxation of loan interest would not be an issue.
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Re: Able to deduct 401K loan interest?

Postby ofckrupke » Thu Mar 28, 2013 5:57 pm

Alan S. wrote:If the loan is not funded with elective deferrals as defined and the exclusion of 72(p)(3) is not applicable, it becomes eligible for deduction. Of course, that brings into play the use of the funds, Sch A exceeding the standard deduction, investment interest limitation to investment income, and for mortage interest, the loan must be secured. It is unlikely that the plan will be willing to secure the loan with the property when they already have the plan balance as security. If all these things fall into place, double taxation of loan interest would not be an issue.


So, notably, not to include state/muni bond income, nor capital gains declared so as to receive favorable rate taxation; nor to mitigate a loss....exclusions I hadn't even thought of, though they clearly make sense in general application...so I am glad I asked. Thanks for your reply!
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