Telling Tips is a series of articles from local experts to help you save money, make better decisions and plan for a better future.
Last week, I discussed some ways to tap into your IRA account without the extra 10 percent penalty. Taxes are always due on withdrawals, but certain plans allow you to borrow from your retirement. Borrowing is not an option from the traditional IRA, the Roth IRA, the SEP, or the SIMPLE-IRA, but it is available through your job or self-employment plans if they are a 401(k), profit-sharing, or Keogh plan.
Borrowing from these plans give you access to your money tax-free, and when you repay the loan, you are paying yourself back at a reasonable interest rate as compared to commercial lenders. But, you must pay back the loan and unless it is for your principal residence, it must be paid back within five years. Improvements to your residence, or to buy a second home, or for a home for other family members do not extend the five year repayment period.
Borrowing Limit: The maximum the law allows you to borrow is the lower of $50,000, or up to half of your ‘vested’ account balance. ‘Vested’ means the money that is yours, even if you leave the company. Generally, your loan is secured by your ‘vested’ account balance.
Note: The 50 percent of your vested account balance is a Labor Department rule, but loans in excess of 50 percent are allowed if additional collateral is provided.
The Negatives: Failing to repay the loan within the required time set by your plan will trigger a report (1099R) to the IRS that you have effectively taken a withdrawal, and if you are not at least 59-and-a-half years of age, you get hit with that 10 percent early withdrawal penalty, plus the income tax on the unpaid portion of the loan (plus state/local taxes). The loan must have at least quarterly payments, and must be paid in full if you leave the company. Finally, you must get your spouse’s approval to take the loan.
Deductible Interest? The deductibility of the interest depends on (1) what part of the loan money is being used, and (2) how the money is used.
Part 1: What Part Of The Loan — Yours Or The Company’s — Is Being Used?
You can’t deduct any of the interest if any of the securing money is from elective deferrals. If your 401(k) or 403(b) was funded only by your employer, that is, you did not make any contribution to the plan, then some of the interest may be deductable, as noted below.
Loophole: If you are borrowing the money to purchase a primary or secondary residency, you can deduct the interest if the property is used as collateral.
In addition, if you are considered a ‘key employee,’ the interest is not deductible. A key employee is an officer of the company whose yearly compensation is more than $165,000 for 2012, or, you own more than five percent of the company, or, you own more than one percent of the company and your yearly compensation is more than $165,000.
Part 2: How Is The Money Used?
If you pass the part 1 hoop, then you must be able to trace the loan proceeds to its use, meaning, personal, business, or investment.
Personal: If you borrow the money to acquire or improve your main or secondary home, this loan interest is deductible. It you use it for qualified educational expenses, the interest is not deductable.
Business: If you borrow the money to start or invest in an S-corporation, partnership, or LCC, that is, a business in which you are active, the interest is deductable.
Investment: If you invest your loan proceeds, the interest is deductable to the extent of your investment income, like capital gains, royalties, and earned interest.
There are a number of additional rules and restrictions, so if this is the option you are looking into, check with your human resources department.
Other questions? Please call your tax preparer, or this office at (718) 332-1040 for clarification or help.
Quip: “I’m proud to be paying taxes in the United States. The only thing is, I could be just as proud for half the money.” — Arthur Godfrey
Have a good week.
Joseph Reisman, of Joseph S. Reisman & Associates, has been serving tax prep and business accounting expertise from his Coney Island Avenue office for more than 25 years. Check out the firm’s website.