Q. Can I borrow money from my retirement account? If so, what are the tax consequences involved?

A. The answer to the first question depends on the type of retirement plan you have.

Borrowing is not available for traditional IRAs, Roth IRAs, SEPs, or SIMPLE IRAs. However, if you participate in a qualified retirement plan through your job or self-employment, such as 401(k), profit-sharing, or Keogh plan, you might be able to borrow some of the funds in your account.

Depending on the circumstances, borrowing from your retirement account could be a smart move. But you must be prepared to pay back the borrowed funds on time, or the tax consequences can be dire.

Before you decide to borrow, take a look at these frequently asked questions to be sure you have the information you need.

How much can I borrow?

The maximum you can borrow from a qualified retirement plan is generally:

• The lower of $50,000 or
• Half of your vested account balance.
• Most plan loans are secured exclusively by the borrower’s vested account balance, although that’s not always the case.

What are the drawbacks?

There are two major drawbacks.

Drawback No. 1 - Your account balance may be irreversibly diminished if you don’t pay the loan back. Why? Because the tax law imposes strict limits on how much can be contributed to an account each year. So you won’t necessarily be able to make up amounts by making bigger contributions later on.

Drawback No. 2 - If you fail to pay back the loan according to its terms, you face harsh tax consequences. Specifically, if you don’t repay it on time, the IRS considers you to have received a taxable distribution equal to the unpaid balance. That triggers a federal income tax liability and possibly a state income tax bill. To add insult to injury, if you’re under age 59 1/2, you may also get slammed with a 10 percent penalty tax.

Bottom Line: Failing to pay back a retirement plan loan is a financial sin for which you’ll pay dearly.

Can I deduct the interest?

It depends. With some exceptions, which we’ll explain later, the standard federal income tax rules for interest expense paid by individual taxpayers also apply to interest paid on a qualified retirement plan loan. Under these rules, your ability to deduct (or not deduct) the interest depends on how you use the borrowed money. In other words, you must trace where the loan proceeds go. Once the borrowed cash has been traced to a personal, business, or investment expenditure, the related interest expense is classified accordingly. Here are the deductibility rules:

• You cannot deduct personal interest unless you spend the borrowed money to acquire or improve your main or second residence or you spend it on qualified higher education expenses. However, in the case of interest on retirement plan loans used for educational expenses, the deduction is not available.
• If you inject the borrowed money into a pass-through entity business, such as an S corporation, partnership, or LLC, and you are active in the business, you can generally deduct the related interest as a business expense.
• If you invest the borrowed money, you can deduct the related interest to the extent of your investment income (from interest, short-term capital gains, and certain royalties).

These are the general rules and they are reasonably favorable. There are also some exceptions to these general rules, and they are less favorable. Your tax adviser can give you more details about possible exceptions.

What about interest on a loan from another plan loans, such as a defined benefit plan? Is that deductible?

Possibly. The general rules listed above apply to you. Under those rules, you may or may not be able to deduct the interest, depending on how you spent the borrowed money. There is an exception, however. You cannot deduct any interest on a plan loan if you are a key employee of the employer that sponsors the retirement plan in question.

A key employee is a person who fits any of these three descriptions:

• You’re an officer of the employer and receive annual compensation above $160,000 in 2011 (unchanged from 2010).
• You own more than five percent of the company that employs you. You must count both your direct ownership percentage, plus indirect ownership under the so-called attribution rules, which are complicated.
• You own more than one percent of the company and receive annual compensation of $160,000 for 2011. Once again, you must count your direct ownership percentage, plus indirect ownership under complicated attribution rules.

For more information regarding record retention guidelines please contact any member of our tax services group.

Read our related and more recent post: How Do I Borrow Money From my 401(k) Retirement Account?