Avoiding double tax on 401k loan interest?

Forum|Forum|3 years ago
November 16, 2022
3 replies
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If you take out a 401k loan, it is commonly said that your 401k loan interest (paid to yourself) is double taxed. If instead of leaving the money in your 401k you roll the after-tax loan repayment and interest repayment into a Roth IRA, do you avoid the second tax? Since my plan only seems to keep track of pre-tax, Roth, and after-tax values and since you can roll after-tax and Roth into an IRA without paying any taxes, I don't see anything preventing you from avoiding the double tax on 401k loan interest this way, but I've never seen this discussed anywhere online.

Opus 17

Employee

Let's assume a $10K loan and over 5 years, you repay $11K. That $1K of interest is from your after-tax funds, and it gets added to your 401k balance, so you pay tax on it again when you withdraw the money in retirement. So I can see how that is "double taxation." However, you are not paying double tax on the earnings and gains that come from having that extra $1000 in the account from repayment to retirement so it is not a total loss.

No, you can't do a conversion or rollover into a Roth plan and avoid the "double tax." You never have a taxable basis in your 401(k), thats per the regulations. All the funds in a 401(k) are considered pre-tax under the law, even if they weren't actually pre-tax, so if you rollover any funds from the 401(k) into any kind of Roth account, it will be a 100% taxable conversion.

JoeVadeAuthor

Regarding your second paragraph, if that's true then what about my Roth contributions to the same 401k account? Or after-tax contributions for the "mega-backdoor" strategy? I know that those can be rolled into a Roth IRA without paying any taxes. It feels like they would need to keep track of the different proportions within the same account or else these common popular strategies wouldn't be possible. So given that, what is it about loan repayments that causes it to get a different treatment than other after-tax amounts, if that is the case?

Opus 17

Employee

@JoeVade wrote:

Regarding your second paragraph, if that's true then what about my Roth contributions to the same 401k account? Or after-tax contributions for the "mega-backdoor" strategy? I know that those can be rolled into a Roth IRA without paying any taxes. It feels like they would need to keep track of the different proportions within the same account or else these common popular strategies wouldn't be possible. So given that, what is it about loan repayments that causes it to get a different treatment than other after-tax amounts, if that is the case?

A Roth-option account inside a 401(k) is different. As is a traditional IRA, where you can keep track of non-deductible basis using form 8606. Each type of account is covered by different laws and regulations even though they have a similar overall purpose. You never have a traceable after-tax basis in a pre-tax 401(k), even if you deposit after-tax money.

If you took your loan from the Roth-option account inside your 401(k), then your interest payments would add to the balance but would not be taxable on withdrawal.

dmertz

Employee

Even though it comes from after-tax funds, I don't think that the interest you pay on the 401(k) loan adds to your after-tax basis in the 401(k). With regard to a 401(k) loan, I believe that you only get an addition to after-tax basis when you repay an amount of a defaulted 401(k) loan which the 401(k) plan treated and reported as a deemed distribution.

opaxson

I have a general 401K loan question. I took out a 401K loan to pay for post grad and still work at the same company and have made all my loan payments on time. I recently did my tax return and upon entering my 1099 for the loan I now owe ~$10K in federal taxes. From everything I read, you don't pay taxes on loans unless you default on the payments or leave the company and then it is recognized as additional income.

VolvoGirl

Employee

Are you sure it was a loan? They don’t send 1099R for loans. It could be an actual distribution. What code is in box 7? Better double check with your employer or the 401K plan.

opaxson

Hi there @VolvoGirl ! Yes it is a loan and I can see the details including repayment schedule, etc. in my account under loans (including the T&Cs for the loan).

The code in that box is "1".