Avoiding double tax on 401k loan interest?

[JoeVade]

Yeah, I was trying to be really specific so as to avoid any weird rules that would take away from the question I was asking, so yes, I'm assuming that nothing age-related comes into play.

So I think you answered my question -- even though I have a single account, the different contribution %s are maintained on the back end, and repaying the loan to my account will be done based on the proportion of the account that the loan was drawn from (i.e., if my account happens to be 50% Roth, 50% pre-tax when I take the loan, it'll get repaid 50% to Roth and 50% to pre-tax, as if I had taken two separate loans from two separate accounts even though I have just one account on the front end). I assume this means that taking a loan out on after-tax (not Roth, but specifically after-tax) amounts would be repaid to the after-tax bucket, which would then be able to be rolled into a Roth IRA since after-tax amounts may be rolled there, which is what I wanted to confirm with my original question.

Or, to illustrate, I could have $25,000 pre-tax, $25,000 Roth, and $50,000 after-tax in a 401k ($100,000 in total), I could take a $50k loan from my single 401k account, and repayments would be distributed proportionately to pre-tax (25%), Roth (25%), and after-tax (50%) amounts. If at the end of this procedure, with no additional contributions and no additional earnings, I have $110,000 (because of the $10,000 in interest I paid on my loan), then 25% of that would be pre-tax ($27,500), 25% would be Roth ($27,500), and 50% would be after-tax ($55,000). I could take my Roth and after-tax amounts ($82,500) and roll them into my Roth IRA. I could also take my pre-tax amount ($27,500) and roll that into my Traditional IRA.

Is anything I said in the preceding paragraph not allowed or wrong?

[Critter-3]

Ok ... you are thinking this way too hard.  You simply took out a loan and paid interest on it as you repaid it.  The interest you paid with after tax money would be the same as if you paid interest on a credit card or personal signature loan.

Now what you don't like or seem to understand is you paid interest to the 401K account which is considered earnings to the 401K account if it is put in that account.  It is normal for a 401K account to be invested in something and have earnings.  ALL distributions from the 401K ( contributions and earnings) are taxable.  The fact that you have to pay taxes on the interest you yourself paid to the 401K loan is how it works  even if it seems unfair. 

[JoeVade]

So this is how it works for me: I have one 401k account through my employer, into which I may elect to contribute pre-tax, Roth, and after-tax amounts (it lets me select what % of my paycheck for each of those three amounts). So when you say stuff like "All distributions from the 401k are taxable", I'm not sure what you mean, because my Roth contributions and their earnings, for example, are not taxable.

I'm trying to get at a very nuanced question here, which I have not seen addressed on any forum, in any article, or even on the IRS's website. Given what I asked in my prior reply, with the scenario I gave, what part of what I said was incorrect? Or, is everything I said correct?

[dmg86]

Did you ever find an answer to this? I have the same question and run into the same issue as you where financial advisors don't understand how ROTH in-plan conversions work so they don't answer the question. 

[dmertz]

@dmg86 , exactly what are you asking about?  This thread covers many questions somewhat unrelated to each other.

An In-plan Roth Rollover is subject to the same taxation as if the distribution had been paid to you (without regard to any early-distribution penalty).

[dmg86]

Sorry I thought I was responding to @JoeVade‘s post. 

If all your contributions have gone through an in-plan Roth conversion and taxed and then you take a loan, is the interest paid back with the loan also a Roth source or is it taxed again on its withdrawal down the road?

[dmertz]

The loan is effectively an investment held by the account and interest paid on the loan is gain on that investment.  Investment gains in the designated Roth account are free of tax and penalty once the age 59½ and 5-year requirements are met.

[JoeVade]

@dmg86 yes I effectively did but it raises more questions. The answer for me is (and I checked on my wife's account too, different company/401k provider) simply they don't let you take out a loan on the Roth portion of your 401k. The pool of money I have to take a loan from consists only of the pre-tax proportion rather than the full amount in the account. In other words, if I had 100% of my 401k money as Roth contributions + earnings thereof, I wouldn't be able to take out a 401k loan at all per my company's (and my wife's company's) setup.

I suspect this is actually a rule since two completely unrelated companies with giant 401k managers (I'm not sure what you call the company that actually facilitates your 401k but one of them is Schwab) wouldn't likely have this action forbidden if it weren't a law. But it could just be one of those things where some places let you do stocks and options in your 401k and others don't. My original question was trying to understand what loan paybacks are categorized as, but it looks like if that one guy is right, they're categorized as earnings, which to me both doesn't make sense and would mean you're double-taxed on them, as you would pay taxes on the money used to pay them back and then pay taxes on everything you withdraw from a traditional 401k, if that were the case. I'll see in a few years though, I took out a loan just to see what would happen and answer this question for myself. I'll try a Roth conversion at the end of the loan so I'll be able to see exactly what is counted towards what. 

[dmertz]

The tax code explicitly permits loans from the designated Roth account and even has accounting requirements for when the loan is split between the traditional and Roth accounts, but it's up to the plan whether or they permit loans to be made from the designated Roth account.

[dmg86]

@JoeVade interesting, I’ll check mine and see if there is some limitation on the source that I can take a loan from. Even if it’s in a year, if you report back on what you find from your loan I’d appreciate it. It’s weird that there isn’t an easy answer for this - and also weird that so many financial planners can’t even understand the question and throw out some explanation that doesn’t answer the question. 

[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]

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". 

[VolvoGirl]

Code 1 is for an early Distribution.  Better check with the employer and/or plan.   @dmertz anything else to add?

[dmertz]

Code 1 reports an regular early distribution and is never used to report anything about a 401(k) loan while you are still employed there.  If you are still working for the company, it seems unusual that the  plan even permit an early distribution unless it was deemed to be a hardship distribution which is not eligible for repayment.  Except as a hardship distribution, elective deferrals are not permitted to be distributed before you reach age 59½ or you separate from service.  Only portions that are employer contributions or investment gains are permitted by the tax code to be distributed. and most plans don't even allow these to be distributed except for hardship.

I think you need to contact the plan to straighten things our.