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Deducting investment interest on a 401(k) loan

George SaenzDear Tax Talk,
I'm thinking of buying a small business as an investment. I have money in a 401(k) at my current employer (I don't plan to leave). If I borrow money from my 401(k) to help make the down payment on the loan, then is the interest that I pay on the 401(k) loan tax-deductible (since the loan was for an investment)? What do you think of this strategy?
-- Doowon

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Dear Doowon,
Certain employer pension plans permit you to borrow money up to the lesser of half of your vested interest or $50,000.

If the loan is for a purpose other than to purchase a home, it must be repaid at regular intervals within five years.

The loan needs to provide for interest. That interest is deductible under the general rules applicable to interest deductions unless you are a key employee of the employer that sponsors the pension plan. The Internal Revenue Service says a key employee is:

  • an officer of the employer having an annual compensation greater than $130,000;
  • a 5-percent owner of the employer, or
  • a 1-percent owner of the employer having an annual compensation from the employer of more than $150,000.

If you don't meet the definition of a key employee and you use the proceeds to buy a business, the interest will be considered investment interest unless you have a passive activity, in which case it would be passive activity interest. A passive activity is an activity in which you do not materially participate in operating the business. It also includes most real estate rental activities. Passive activity interest is limited to passive activity income. Investment interest expense is limited to investment income.

As far as the idea, I think it's excellent and that you should set a good rate of interest to maximize your deduction. It's an excellent strategy because in effect you are borrowing from yourself, paying it back to yourself and creating a tax deduction on one side and deferring income on the other side.

-- Posted: March 23, 2005





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