Avoiding double tax on 401k loan interest?

[JoeVade]

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]

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. 

[JoeVade]

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]

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@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? 

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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]

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.

[JoeVade]

What about the mega backdoor strategy? That involves contributing after-tax to a traditional 401k and then rolling it into a Roth IRA without needing to pay taxes to roll it over. Since I know that's possible, the traditional 401k would need to track after-tax contributions in order for them to know what to withhold when you do the rollover.

[Opus 17]

@JoeVade 

I am only familiar with employer sponsored 401(k) plans, and to the best of my knowledge, you can’t make after-tax contributions to a pre-tax 401(k), and you can’t make any contributions to the 401(k) except through payroll deductions.

If you are referring to a strategy involving making after-tax contributions to a solo self-employed 401(k), you will have to discuss that with someone who has more expertise in that area.

[JoeVade]

In my case, my plan is employer sponsored and my roth and traditional contributions go into the same account, so there's no way for me to say which holding corresponds to pre-tax vs after-tax vs Roth as they are all in the same pile -- it is possible, however, to determine and track the % pre-tax, % after-tax, and % Roth of the entire account as a whole, which is why I'm wondering about my original question. 

[Opus 17]

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@JoeVade wrote:

In my case, my plan is employer sponsored and my roth and traditional contributions go into the same account, so there's no way for me to say which holding corresponds to pre-tax vs after-tax vs Roth as they are all in the same pile -- it is possible, however, to determine and track the % pre-tax, % after-tax, and % Roth of the entire account as a whole, which is why I'm wondering about my original question. 

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I'm not familiar with your situation, my retirement plans have always been held at big investment firms (Fidelity, T Rowe Price, etc) and the pre-tax and after tax funds are held in separate accounts.  Here, you may have one overall account but two internal accounts for bookkeeping purposes.  Or, the trustee needs to be keeping really good track both of pre-tax and after-tax contributions, and the earnings that can be allocated to the pre-tax and after-tax funds.

It's also not clear to me how, under your plan, the loan would be funded.  Is it funded from the pre-tax side, the after-tax side, or both, and who decides?  Can you choose to borrow only from the pre-tax or after-tax side?  Loan interest should be allocated in the same way as the loan balance.  If the loan was funded from the pre-tax side, the interest has to go into the pre-tax side, resulting in "double taxation" as you call it.

I am doubtful you could legally assign the interest to the after-tax side if the loan principal came from the pre-tax side.  If you are planning ahead and haven't taken the loan yet, could you take it from the after-tax side only?

I'm also concerned about whether the trustee can really accurately allocate earnings if the funds are co-mingled.  Possibly, you misunderstand how your funds are held.  If not, I might want to the issue as a concern with your employer or the trustee and see how they explain things.  You may want a review from a high level accountant who is trained on these types of plans.  I wouldn't want you to be disadvantaged because of something your employer did 20 years before.  Not that I know something is wrong, I am just concerned by your description and I don't have all the facts.

Depending on your income and other tax situations, it might be worth considering making only pre-tax contributions at work and making your after tax contributions to a private Roth IRA that you can set up at a broker of your choice, you can contribute up to $6000 per year depending on your income, or you can contribute to a non-deductible IRA and do a "backdoor" conversion, again up to $6000 per year (or $7000 if age 50 or older).  If all the work money is pre-tax, that will avoid confusion in the future.  

The bottom line for me is that your situation has some twists and turns that I don't fully understand, but I don't know of a way to repay a loan from a pre-tax 401(k) and have the interest go to an after-tax (Roth) account instead of the pre-tax account.  You may want to consult a paid professional expert in your area. 

[JoeVade]

The mega-backdoor thing I'm referring to is described here, for example (https://www.nerdwallet.com/article/investing/mega-backdoor-roths-work). My company used to use Fidelity and now uses Alight, and in both instances when I contributed Roth/traditional/after-tax amounts, they went to a single account. So if I contributed $50,000 in a single year, with $10,000 pre-tax, $10,000 Roth, and $30,000 after-tax to an empty account, then my Fidelity/Alight 401k would show me as having 1 401k account with $50,000 in it. Now, I understand that earnings on after-tax contributions are considered pre-tax amounts, so if my $50,000 doubled to $100,000 without any further contributions, the new amounts would be $50,000 pre-tax, $20,000 Roth, and $30,000 after-tax -- the nominal amount of after-tax amount in the 401k never increases without further contributions, as far as I'm aware, because any earnings on after-tax amounts are considered pre-tax.

Now, what I gather from what you're saying is that a loan repayment, made with after-tax dollars, will be allocated as pre-tax or Roth depending on whether the loan came from the pre-tax funds or the Roth funds. If that's the case, then that is at least consistent, but is there anywhere where it spells out exactly how the loan repayment should be treated for the purpose of rollovers? I ask because of the following specific hypothetical:

Let's say my 401k account can take pre-tax, Roth, and after-tax contributions to a single account, with accounting on the back-end to allow contribution bases to be tracked. I contribute $20,000 pre-tax and then take out a $10,000 loan, repaying it over time with interest such that my new balance is $22,000 (= $10,000 not loaned + $10,000 loaned + $2,000 interest). Since the repayments are after-tax, and would need to be reported as such to prevent me from deducting them on my tax return, they must add to the "after-tax" pool in my 401k. However, maybe I decide to roll everything (all $22,000) into one or more IRAs. It is true that after-tax amounts can be rolled to Roth IRAs without paying any additional taxes (else the mega-backdoor Roth IRA would not be possible) and it is true that $12,000 of my account in this scenario is after-tax, so would it be true that I can take the $12,000 in after-tax amounts from my account and roll it into a Roth IRA, while taking the remaining $10,000 traditional amount and rolling it into a traditional IRA? If not, where along this sequence of events have I made an illegal move or assumed something incorrect?

[dmertz]

Ignoring the interest payments, the repayment of the loan is simply putting back the money that you took out.  It's not treated as either pre-tax or after tax unless you default on the loan, in which case the loan becomes a deemed distribution that is taxable in the same pro-rata manner as would be an ordinary distribution.  Because the amount of the deemed distribution will now have been fully taxed, subsequent repayments of the loan that had been declared to be a deemed distribution will become after-tax basis in the 401(k).

Also, after-tax contributions, Roth contributions and pre-tax contributions and their attributable earnings are all tracked with separate, independent accounting.  This separate accounting effectively makes them separate  sub-accounts, not treated as a single account.  The after-tax sub-account (with its attributable earnings) can be distributed separately from the others, so the pro-rata calculation of the taxable amount of a distribution from the after-tax sub-account would be based only on the funds in the after-tax account.  This is why the mega-backdoor-Roth works.

IRS Rev. Proc. 2020-46 allows a for single distribution to be split and rolled over to two separate accounts with the taxable portion of distribution going to a traditional IRA and the after-tax portion going to a Roth IRA.  If not done as a single distribution, the pro-rata calculation would mean that a rollover to a traditional IRA would result in some portion of that distribution being after-tax money that becomes nondeductible contributions in the traditional IRA and some portion of the separate rollover to the Roth IRA being taxable.

[JoeVade]

So if that's the case, how does all of that fit into the ability to take a loan out? Effectively, I'm trying to skirt the maximum contribution limits by taking out a maximal ($50,000) loan and repaying it with interest, then rolling over everything into a Roth and traditional IRA, as appropriate. I reckon that if I max out my 401k contributions every year and also have the interest of a $50,000 loan getting paid back, then at the current 2022 limits and rates, I should have been able to contribute $61,000 ($20,500 employee contribution + $40,500 after-tax contribution) plus repay $12,000 (divided into principal + interest) of my loan, with that extra $2000 (=$12,000 payment - $50,000/5 years) being an amount I could not possibly have placed in my account without penalty through any other means -- in effect, if I took a $50,000 loan from my plan this year, I would be able (because my plan allows it) to contribute the max amount while repaying the loan, meaning at the end of 5 years I would have contributed the max amount each year, plus repaid my $50,000 with $10,000 interest. That $10,000 interest is extra money in my plan -- all I want to know is, when I roll that interest into an IRA, do any parameters of the loan (i.e., if the loan was taken from pre-tax, after-tax, Roth, or a mixture of funds) affect what I can roll that $10,000 into?

[dmertz]

The loan and its repayments with interest have no bearing on the amount that you are eligible to contribute to the 401(k).

[JoeVade]

Right, that comports with what I've seen online. However, based on my discussion with the other guy further up the thread, the following two scenarios may differ:

Scenario 1: I have a 401k holding only Roth contributions and earnings, and I take a $50,000 loan from it, repaying it in 5 years with an additional $10,000 in interest, and then rolling as much of it as I can into a Roth IRA without paying taxes on it (and the rest, if applicable, into a traditional IRA).

Scenario 2: I have a 401k holding only pre-tax contributions and earnings, and I take a $50,000 loan from it, repaying it in 5 years with an additional $10,000 in interest, and then rolling as much of it as I can into a Roth IRA without paying taxes on it (and the rest, if applicable, into a traditional IRA).

So my follow-up question would be: Is the amount rolled into a Roth IRA a) the same in both scenarios or b) different in each scenario. Additional questions: Was anything rolled into a Roth IRA in Scenario 2? Was anything rolled into a Traditional IRA in Scenario 1? (Note: If the answer to the first question was a), then one of these two answers must be yes)

[dmertz]

In Scenario 2, any amount rolled over to the Roth IRA would be taxable because there is no after-tax basis in the 401(k).  Scenario 1 none of the rollover to the Roth IRA would be taxable.  Whether or not distributions from the Roth IRA would be taxable would depend on your age, the year for which you first made a Roth IRA contribution (including a rollover) and whether or not the Roth account in the 401(k) was qualified at the time of the rollover.  You mentioned a 401(k) contribution limit of $61,000 for 2022, so you are apparently under age 59½ and neither the Roth account in the 401(k) nor the Roth IRA would be qualified yet.

Nothing from the Roth account in a 401(k) is permitted to be rolled over to a traditional IRA, nor would you want to.