401(k) Loans and mortgage interest expense

Most people think of their 401(k) as a “hands off” asset that can’t be touched until retirement.  Although this is sound strategy for retirement planning, the 401(k) can be a source of short-term funding that will continue to grow despite being withdrawn now for other purposes.  Depending upon your plan policies, 401(k) participants can take a loan from their accounts in an amount up to $50,000 (limited to 50% of your account value) at a 3.25%-5.25% interest rate without recognizing the loan amount as income (as would otherwise happen upon receiving a distribution from a 401(k)).  This means that although retirement account assets have been diverted away from the account for 5 years and the participant has lost out on 5 years worth of stock market appreciation (or losses), there has been a guaranteed 3.25-5.25% per year return by simply paying the loan back.  And since the 401(k) is yours when you retire, you are paying yourself back by simply shuffling money from one pocket to another.

What if you could turn the otherwise non-deductible 401(k) loan into a tax deductible loan by securing the loan with a deed of trust on your residence?  That would be the best of all possible worlds – guaranteed returns of 3.25%-5.25%; paying oneself instead of someone else; and deducting the interest paid for a tax benefit.   It is possible, but unfortunately, only in very limited situations, such as for non-key employees.  Furthermore, tax deductions for interest is limited to interest accrued on non-elective deferrals (i.e. appreciation in the account or employer-deposited amounts). However, if you fall into this small category of individuals, the results can be worthwhile, as illustrated below.


  1. Non-key employee;
  2. 401(k) with a significant non-elective deferral balance;
  3. $50,000 of student debt at a 8% interest rate (which is entirely or partially non-deductible, depending upon income level); and
  4. Also owns a home.

If this person were to take a $50,000 loan from the 401(k) at a 3.25%-5.25% interest rate and secure the loan with a Deed of Trust on the home, this person could deduct the interest expense on the $50,000 401(k) loan and save 2.75% – 4.75% (the difference between 8% and 3.25%-5.25%) on the interest rate over the life of the loan.  Furthermore, by securing the 401(k) loan with a Deed of Trust, the 5 year repayment period can be extended, thus reducing the monthly payment.


Although this seems like a no brainer, there are many potential issues with this plan to consider (other than the issue presented above relating to key employees and elective deferrals) and you should consult your tax adviser prior to taking out a 401(k) loan.  For example, all of the benefits (such as forbearance and deferment) of having public student loans disappear when you pay them off with the 401(k) loan.  Furthermore, itemized deductions can be limited based upon your income levels and home equity debt is limited by the Alternative Minimum Tax.  Lastly, if the stock market has a gangbuster year, you could miss out on significant appreciation.  On the flip side, though, if the stock market has a bad year, you will have had a good year simply by paying yourself interest.


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