As you already know, interest expense isn't simply deductible because it's interest. Any of you who have paid interest on a credit card know that's the case. Nope. In order to be deductible, interest must be defined as such in the Internal Revenue Code. For example, interest that you pay on your home is defined as mortgage interest. Interest that you pay on funds used to purchase investment assets would be defined as investment interest. Interest that you pay on credit cards is defined as completely non-deductible.

So what does the tax code say about interest paid on loans that you've taken from your company retirement plan or 401(k) plan?

Loans and retirement
While I generally don't like to see folks borrow against their retirement plan, it actually does make sense in at least a few cases. It provides you with access to your retirement plan money (within limits) without getting hit with the 10% early distribution penalty for distributions prior to age 59 1/2. You basically pay interest to yourself on the loan, which is much better than paying interest to a commercial lender, bank, S&L, or credit union.

Retirement plan loans are generally easy to obtain. There are not a lot of expenses attributed to them. And if your credit is less than golden, you might find it easier and cheaper to borrow from your retirement plan than from a commercial lender.

Who can get a retirement plan loan?
Remember that loans are only allowed if the plan permits them. In this day and age, most plans do allow for loans to participants, but if you're thinking about tapping your retirement plan for a loan, make sure that you check with the benefits folks at your place of employment before spending the cash.

Generally, the maximum amount that you can borrow is the lesser of $50,000 or 50% of your vested account balance in the plan. So the funds that you can get your hands on aren't insignificant, depending on the balance in your account. Also, most plan loans are secured exclusively by your vested account balance, so there is no additional collateral required.

The tax code allows for a loan of up to $10,000 regardless of your vested account balance in the plan. But the Employee Retirement Income Security Act (ERISA) rules require the plan to obtain additional security for any loan amount in excess of 50% of your vested balance. Because of this dichotomy in the rules, most plans simply allow for loans that don't exceed 50% of your vested balance.

There are two potential big ones when you take a loan against your retirement plan. The first is the fact that your account might not be growing as quickly as it should. It's quite possible that the interest that you're paying on the loan is much less than the return that could be obtained by other allowable plan investments. That lack of growth for a period of time can impact your retirement benefits in the future.

But by far the biggest pitfall is if the loan isn't repaid according to the terms of the loan. If the loan isn't repaid, it's considered a "deemed distribution" of the unpaid loan balance. That means that you now have additional taxable income in the year that the loan was unpaid, but you might have taken the actual cash months or years ago. Ouch.

And it gets worse: If you're younger than 59 1/2, that deemed distribution will be considered "early" and will also be subject to the 10% early distribution penalty. Double ouch. Depending on how your state taxes the distribution, you could see as much as 50% of the "deemed" distributions go away in taxes. And, since you've likely already spent the money some time in the past when you made the loan, it's likely that you now don't have the funds to pay the taxes. This is especially painful when you leave your current employer (via either quitting or termination) with a balance against your retirement plan. The loan is deemed unpaid and distributed. If you're terminated, this deemed distribution (and likely penalty) simply rubs salt into an already deep wound.

So make sure that you think things through before you make the decision to borrow against your retirement plan. But once you have made the decision, let's discuss how you'll handle the interest that you pay on those loans.

Qualifying retirement plans
Before we get too far, let's make sure that we're all talking about the same thing. Remember that there are no provisions to borrow against your IRA (either traditional or Roth), SEP, Keogh, or SIMPLE plan. What we're talking about here are qualified retirement plan loans such as those against your pension, 401(k), or 403(b) plans.

With some very important exceptions, interest paid on a retirement plan loan must be "traced" to determine the use of the funds. If the funds are used for personal purposes, then the interest is generally not deductible. But if the proceeds are used for qualified residence, education, business or investment purposes, and you can trace the proceeds of the loan for such purposes, then you would likely have an interest deduction based upon those provisions of the laws.

Seems simple so far, but as with most tax laws, what seems simple on first blush normally isn't simple at all.

Exceptions for 401(k) and 403(b) plan loans
The law says that interest paid on a loan secured by your account balance is non-deductible if any of the account balance used to secure the loan is attributable to elective deferrals that you made. Well heck, that's why you signed up for a 401(k) or 403(b) plan - to elect to defer part of your wages into the plan. So it's easy to see that this exception virtually prohibits an interest deduction for interest that you pay on loans against your 401(k) or 403(b) plan. It's possible that the vested balance in your account is totally from non-elective employer contributions, but extremely unlikely. So generally, interest that you pay on your 401(k) or 403(b) loan is non-deductible, regardless of how the loan funds were originally used.

Exceptions for other plans
Think you're in the clear since you're borrowing from your pension plan and not your 401(k) plan? Well, you could be, but there is another exception that you must overcome: You can't be considered a "key employee." If you're considered a key employee, the interest that you pay on your loan is considered non-deductible. A key employee is anybody who fits one of the following three definitions (note that you only have to fit one, and not all three, to be a key employee):

  • An officer of the organization with annual compensation exceeding $130,000
  • A more than 5% owner of the organization, whether the organization is a corporation, partnership, or LLC
  • A more than 1% owner of the organization and your annual compensation exceeds $150,000

If you don't fit the "key employee" definition, then you can deduct the interest you pay on your pension plan loan from a plan other than a 401(k) or 403(b), as noted above, and trace the proceeds and deduct the interest as allowed by law. If you are deemed a key employee, then your interest is non-deductible. Period.

Think first
Too many folks borrow from their retirement plans without thinking or planning. One of the reasons that they borrow from their plans is that they believe that the interest on the loan would be deductible. As you can now see, in most cases that interest will be completely non-deductible. So when you consider the pitfalls on these pension plan loans in conjunction with the non-deductibility of the interest that you pay on the loan, you'll want to consider alternative options before you take that loan from your pension plan.

Related reading

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.