Traps To Avoid With Your 401k Loans

You are allowed to borrow half of the value of your 401K, up to $50,000 limited to 50% of the value of your account. You are required to charge yourself a reasonable rate of interest. The interest is not tax deductible because it is not a mortgage. So the interest your 401K earns will eventually be withdrawn when you retire and withdraw funds from your 401K, at which time the interest is taxed. But there is no symmetry in the tax code because you can’t deduct the interest expense when you made payments to your 401K, yet you must pay tax on the withdrawals from a 401K.

401k Real Estate Loan

401K’s allow for a 15 year amortization for real estate loans, provided the Custodian has agreed to it in the Plan documents. A Custodian may not have bothered to set up this feature. Also I do not know if any Custodian has bothered to structure a 401K loan as a formal mortgage.;

Since Custodians are trying to keep costs reasonable and avoid complexity then I doubt any of them would have bothered to allow a formal mortgage documentation process just to help someone get a tax deduction for a few thousand dollars of interest payments. Sponsors and Custodians of 401K’s are not required to give account holders all of the features that the law allows. If someone obtained a 401K and terminated employment they would usually have to pay back the 401K loan immediately, although some employers allow ex-employees to keep their 401K and continue the loan after they leave the company. Imagine the politics of an employer firing someone and then demanding immediate repayment of a 401K loan that was a mortgage, resulting a foreclosure. It would be cruel to do that, so the employer would probably not offer it as a mortgage.

To be tax deductible it would have to be recorded as a mortgage and not an unsecured loan. Further the loan could not be a cash-out refinance, except that a borrower is allowed $100,000 cash-out loan on his home as long as it does not exceed 100% of current value. Thus if the home had no previous cash-out refinances and has not declined in value then maybe it would be allowed. Please see your tax advisor for details.

The Real Costs

My quick estimate of the tax asymmetry is that it will cost you $2,000 for $50,000 which is 4% (based on total expenses and deductions over the life of the loan, plus tax paid when making withdrawals). If the loan is for the purpose of paying off credit card debt then it is a no-brainer to suffer this tax injustice so as to avoid paying 22% for a credit card.

Early retirement withdrawals with no penalty from 401K’s

When withdrawing from an IRA one must be at least age 59 ½ to avoid an early distribution penalty (exceptions may apply). However if one will be over age 55 by the end of the year in which they are “separated from service” then they can withdraw from a 401k with no early distribution penalty. Thus someone turning 55 in December this year who lost his job this January when he was 54 can withdraw from the 401k without an early distribution penalty. However, they must not become unemployed before the year they turn age 55. So if you lose your job at age 53, then the day before turning 55 get a job and then quit the day you turn 55 so that you can start withdrawing from your 401k which you would have to have kept at the old employer. However, most people roll a 401K into an IRA when they change jobs, so to be able to make the withdrawal one must keep the 401K with the old employer. If the employer went out of business then this might not be possible. It may be possible to roll the 401K to a new employer’s 401K but the fine print in the sponsor's (the sponsor is the employer) Plan documents would have to allow that. Both the Custodian that holds the funds and the sponsor (employer) need to authorize the formation of a policy such how 401K loans are created. They may be afraid of litigation or bad political consequences and want to cut costs so they may choose not to offer certain exotic features

So if you lose your job at age 53 you might be able to borrow from your 401K if the employer allows you to keep your 401K. Then when you turn 55 you find a job and then quit so that you can make penalty free withdrawals. This way you will have gotten funds penalty free out of your 401K since age 53.

Of course the best thing is to avoid being unemployed and avoid debt and use a 401K for what is intended for, as a savings vehicle and not a source of early retirement withdrawals.

A Final Trap

Another tax trap is that 401K withdrawals are taxed as ordinary income, thus negating the benefits of long-term capital gains that occurred inside of a retirement account. If someone had the ability to make long-term gains then they may be better off building wealth in a taxable account instead of a retirement account, assuming they had no employer matching contribution. However, diversification implies that one should hold some bonds and the best place for bonds is in a retirement account.

About the author

Don Martin, CFP®

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