Avoiding double tax on 401k loan interest?

Forum|Forum|3 years ago
November 16, 2022
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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

Level 15

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

Level 2

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?

dmertz

Level 15

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?

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.

dmertz

Level 15

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

Level 2

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

Level 15

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

Level 2

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".