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Mystery for the Ages Solved! Is Interest on Plan Loans Double-Taxed?

12/16/2019
By Jack Towarnicky

We have the answer! It ranks right up there with “what’s out there beyond our solar system”?1 and “Who am I? Why am I here?”

Mechanics of Taking a Loan, Making Loan Payments
All monies in an individual account retirement savings plan are tracked at least two ways – by the source of the monies and by the investment allocation. So, whenever money is added to a plan, it gets credited to a specific “source bucket” and monies are concurrently allocated into one of the available investments based on the participant’s election (or per the QDIA). Typical “source buckets” are:

  • Pre-tax 401(k) or 403(b) deferrals 
  • Roth 401(k) or 403(b) deferrals 
  • Employer matching 401(a) contributions 
  • Employer non-elective 401(a) contributions 
  • After-tax 401(a) employee contributions, and 
  • Monies rolled over into the plan. 

There are an equal number of “earnings buckets”, one for each of the “source buckets” – because plan provisions sometimes restrict earnings (such as earnings on 401(k) contributions and hardship withdrawal provisions).

Loan principal never leaves the plan. A plan loan does change the investment allocation – the loan principal is typically allocated to a “loan account” – where the monies are not invested in debt securities of a bank, financial institution, etc. but become a fixed-income investment for the participant. So, there is no tax effect on the principal when the loan is initiated nor when the loan is repaid. Each loan payment includes loan principal and interest. When repaid, the loan principal is moved from the “loan account” to the investments selected by the participant. Unlike the principal, each payment of loan interest has the same qualities as any other positive return on investments – increasing plan assets. It too is allocated to the investments selected by the participant.

So, for example, if a plan only has 401(k) pre-tax deferrals, the plan loan principal never leaves the 401(k) pre-tax deferral “source bucket” and loan interest is allocated to the 401(k) pre-tax deferral earnings bucket.
One Exception: Under almost all 401(k) plans, the plan loan interest a participant pays is credited directly to the participant’s account. However, there are loan structures where a loan is treated as just another interest-bearing security within a fund (a bond fund, a money market fund, or sometimes the general account of an annuity provider). You might see this in 403(b) plans and/or in defined benefit /defined contribution pension plans. Is such designs, loan principal is moved to the designated investment option and the interest a participant pays is comingled with the interest or earnings on other securities in that investment option.

Taxation of Plan Loan Interest
All loan interest, whether paid on a commercial loan or on a plan loan is always paid with after-tax dollars. We are left with two questions:

  • Is there a tax deduction on the interest component of the loan payment, and 
  • Is the interest taxable when distributed from the plan? 

Under current tax code provisions, interest on a loan secured with a mortgage that otherwise meets tax code requirements may be tax deductible – whether the loan was sourced from a tax qualified plan or a commercial source. So, yes, if you have a plan loan that was used to finance the acquisition of your main home or second home (buy, build, or substantially improve), the interest you pay to your own 401(k) account may be tax-deductible. (Hint: I have done this myself in the past when interest on home equity loans was tax-deductible).

A distribution of earnings, including the interest you paid on a plan loan, is taxable on the same basis as would apply to interest on any other fixed income investment. So, whether the interest is paid based on a bond investment or the interest was paid by you as part of a plan loan, it is taxable income when distributed from the plan – with one exception.

The exception is if the principal used to secure the loan was Roth 401(k) contributions, but only if the Roth monies remained in the plan long enough to meet the 5-year, age 59 ½ requirements. In that situation, the interest you paid on your plan loan may be distributed tax free.

Conclusion
Yes, the interest on a loan is always paid with after-tax dollars that did not qualify for a tax deduction (except where the plan loan was properly secured with a mortgage). And, yes, a participant must pay taxes on interest received from the plan whether it was interest from an investment or interest the participant paid on a plan loan (unless the principal was Roth 401(k) monies and the interest ultimately qualifies for tax free treatment upon distribution).

But, are the same dollars “double taxed”? No. Simply, these are different amounts – loan interest the participant paid and earnings the participant received from investments.

For comparison, had a participant borrowed from a commercial source, she would have paid interest with after-tax dollars but would not have received the interest she paid on that loan. And, say a participant contributed Roth 401(k) dollars in 2007, took a $1,000 loan with 5% interest to be repaid in a year, suspended her contributions, paid the loan back, but then suffered substantial investment losses due to the market decline of the Great Recession. Her investment earnings would be negative, and she would only receive a portion of the Roth contributions she had made - no taxes would be due.

Bottom line, other than the exceptions detailed immediately above, there is no option to make loan interest payments with pre-tax contributions (whether the loan was sourced from the plan or from a commercial source) and there is no option to receive earnings from the plan tax free.

You can call it double-taxation if you like. Me, I say these are not the same dollars.


We are providing this information to you solely in our capacity as individuals with knowledge and experience in the industry and not as legal advice. The issues presented here may have tax or legal implications, and we recommend discussing this matter with your tax or legal counsel prior to choosing a course of action. This publication was prepared to support the informational needs of the Plan Sponsor Council of America on the issues discussed. The publication focuses on the needs of our association and the issues of interest to association members. The publication is not and should not be used as a substitute for legal, accounting, actuarial, or other professional advice.


1J. O’Callaghan, Voyager 2 Makes an Unexpectedly Clean Break from the Solar System: The first scientific results from the spacecraft’s exit into interstellar space have been published, revealing a simpler departure than its predecessor. Scientific American, 11/4/19. Accessed 11/8/19 at: https://www.scientificamerican.com/article/voyager-2-makes-an-unexpectedly-clean-break-from-the-solar-system/

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