If your company offers a qualified retirement plan or if you're self-employed and have set up a 401(k), profit-sharing, or Keogh plan, you might have the option to borrow from your retirement account. This option isn’t available for traditional IRAs, Roth IRAs, SEPs, or SIMPLE IRAs, but for qualifying plans, taking out a loan can be a strategic financial decision.
The main benefit is that you can access your retirement funds without incurring taxes, provided you repay the loan. Additionally, when you repay the loan with interest, you're effectively paying interest back to yourself rather than to a commercial lender. However, it's essential to repay on time to avoid severe tax penalties.
Here are answers to common tax questions about retirement plan loans.
How Much Can I Borrow?
Typically, the maximum amount you can borrow is the lesser of:
$50,000, or
50% of your vested account balance.
Most loans are secured by your vested account balance, though there can be exceptions.
Potential Drawbacks
There are two significant risks to consider before borrowing from your retirement plan:
Irreversible Reduction in Retirement Savings: If you don’t repay the loan, your account balance could be permanently diminished. IRS rules on contribution limits make it challenging to replenish the funds.
Tax Penalties for Defaulting: If you fail to repay the loan, the IRS will treat it as a taxable distribution. This can lead to federal income taxes, and possibly state taxes, along with a 10% penalty if you're under 59 ½.
Is the Interest Deductible?
It depends on how you use the borrowed money:
Personal expenses typically don’t qualify for a deduction unless they are for home improvements or qualified higher education expenses.
Interest is generally deductible for business use, like injecting the loan into a pass-through entity (S corp, LLC) where you're active.
Investment-related loans may allow you to deduct interest up to the amount of your investment income.
Exceptions for 401(k) and 403(b) Plans
For 401(k) and 403(b) loans, interest usually isn’t deductible if the loan includes salary reduction contributions (elective deferrals). These plans typically consist of contributions from salary reductions, so in most cases, the interest won’t qualify for a deduction.
Interest on Other Plans
Loans from defined benefit pension plans or profit-sharing plans have a better chance of allowing a deduction, as long as they meet IRS requirements. However, key employees (officers or those with significant ownership) usually cannot deduct interest on these loans.
Conclusion
While retirement plan loans offer flexibility, they come with risks and complex tax rules. If you’re considering taking out a loan, consult a tax professional to ensure you understand the financial and tax implications.
Contact Verity CPAs at info@verity.cpa or call 808.546.5026 for personalized advice on navigating retirement plan loans.
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