Tax Tips by Phil Goldstein

From Phil Goldstein, Managing Director of Goldstein Lieberman, Co.

Can You Borrow From a Retirement Plan?

Can you take a loan from your retirement plan? In a word…maybe. If your plan is a 401 (k), profit sharing or Keogh, the answer is a qualified “yes”. But if it’s a traditional IRA, a Roth IRA, SEPs or SIMPLE-IRAs it’s a “no”.

The good news is that a plan loan could give you access to at least some of your retirement account money without having to pay taxes. The interest rate will generally be low and, you would be repaying yourself rather than a lending institution.

How much can you borrow?

If a plan provides for loans, the plan may limit the amount that can be taken as a loan. The maximum amount that the plan can permit as a loan is the greater of $10,000 or 50% of your vested account balance, or $50,000, whichever is less. For example, if a participant has an account balance of $40,000, the maximum amount that he or she can borrow from the account is $20,000. Most plans are secured exclusively by the borrower’s vested account balance but there are exceptions even here.

The bad news is that if you don’t follow the rules to the letter, you face severe tax consequences.

Here are some potential pitfalls: If you don’t pay the loan back, your balance may be irreversibly diminished. Remember, there are strict limits on how much you can contribute each year. You won’t necessarily be able to make bigger contributions later on. Plus, if you don’t repay it on time, the IRS will consider the loan a taxable distribution equal to the unpaid balance. That means a federal and possible state income tax liability. What’s worse, if you’re under 59 ½, you may be assessed a 10 percent penalty.

Is the interest deductible?

In general, the standard federal income tax rules for interest expense paid by individual taxpayers will apply. These rules say your ability to deduct interest depends on how you use the loan. If you spend it to acquire or improve your main or second residence you could be okay. You may also use it to fund a pass-through entity business like an S corporation, partnership or LLC as long as you’re active in the business. If you invest it, you can generally deduct it to the extent of your investment income.

There are exceptions to these general rules and what you don’t know can hurt you. Most likely, the interest expense is nondeductible. For example, you usually can’t deduct interest on a 401 (k) or 403 (b) if any of the account balance used to secure the loan comes from “elective deferrals” (contribution arrangements of an employer-sponsored retirement plan in which participants choose to set aside part of their pretax compensation as a contribution to the plan).

You need to know the details of your plan because many of the rules are tricky. Ask your tax adviser for to answer any and all questions. The funds could help you over a hurdle, or they could cause you to step out on very thin ice.