Retirement Plan Loan Interest
Individuals who participate in qualified retirement plans [401(k), corporate profit sharing plans, and the like] sometimes borrow from those plans and pay interest on their loans. In essence, the participants pay interest to themselves when they take out plan loans. Plan loans provide participants with access (within limits) to their retirement plan money without incurring the income and penalty taxes that generally apply to retirement account withdrawals before age 59½.
401(k) and 403(b) Plan Loan Interest: 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. Since the participant’s account will almost always be required as security for a plan loan and 401(k) and 403(b) account balances will almost always include at least some elective deferral dollars, interest from such plan loans will rarely be deductible. In the unusual case where the participant’s account balance has been funded entirely by nonelective employer contributions and related earnings (or the loan is secured solely by these amounts), the tax treatment of the interest expense is determined by following the general rules for individuals, as summarized below. Bottom line, interest on 401(k) and 403(b) plan loans will almost always be nondeductible.
Other Plan Loan Interest: Under general federal income tax rules, the participant’s (borrower’s) use of the loan proceeds determines whether and to what extent the related interest expense can be deducted. Specifically, interest paid on a plan loan, other than a 401(k) and 403(b) plan loan (see above), traced to a personal, business, or investment use is classified accordingly. In a nutshell, personal interest expense that is not qualified residence interest is generally nondeductible. Business interest expense is generally deductible and investment interest expense is generally deductible to the extent of the participant’s net investment income. However, for any period beginning when the participant becomes a key employee (based on compensation and stock ownership guidelines), the interest paid on the plan loan is completely nondeductible.