401k Loan Double Taxation Myth
July 30, 2008 by TFBI don’t know who started it. Suze Orman certainly helped spread it. She says that you shouldn’t borrow from your 401k (or 403b) plan because you will be double-taxed. I did a Google search and I found 5 priceless money-saving tips by Suze Orman:
"Also, never ever borrow against your 401k plan because you will pay double taxation on the money you borrow. Because you don’t pay taxes on the money you put into a 401k, when you pay back the loan (which you must do within five years, or 15 years if used to buy a home), you pay it back with money you have paid taxes on. Then, when you retire and take the money out again, you end up paying taxes on it a second time."
This allegation is all over the place — MSN, USA Today, The Motley Fool, Moolanomy blog. It is a myth because there is NO double taxation. It’s a mind trick similar to that well-known "where’s the missing dollar" puzzle.
"Three men went into a hotel. The manager said the room was $30 so each man paid $10. A while later the manager realized the room was only $25 so he sent the bellboy to the 3 guys’ room with $5. The bellboy only gave each man $1 back and kept the other $2 for himself. Now 3 men paid $9 each for the room, which is $27. Add the $2 that the bellboy kept, and that’s $29. But the 3 men paid $30 originally. Where is the other dollar?"
I was able to find a good explanation for this puzzle. The $30 number is irrelevant. The correct math is $27 - $2 = $25. It makes no sense to add $2 to the $27 because it’s already a part of the $27. The $2 should be subtracted from the $27.
Now, back to our 401k double taxation myth. The fact that the loan has to be repaid with after-tax dollars is irrelevant, just like the $30 number in the hotel puzzle. If you didn’t borrow from the 401k plan but you borrowed from a bank, you’d have to pay the bank back with after-tax dollars as well. If you didn’t borrow from your 401k plan but you dipped into your own savings, you have to replace those savings with after-tax dollars too. What it really means is that a 401k loan is not tax deductible, just like any other consumer loan except a mortgage or a HELOC. Instead of saying you will be double taxed, they should just say that a 401k loan is not tax deductible, plain and simple.
I have this post in draft for a long time but Jonathan at My Money Blog beat me to it recently with two posts trying to debunk this myth (post 1, post 2). After so much discussion some folks are still not convinced. I think this issue is best illustrated by this chart below:
The left hand side represents a typical consumer loan, like a car loan. The arrows represent "borrows from" and "pays back to." You borrow from a bank. The bank borrows from the financial market. Your 401k invests in the financial market. I think we all agree there is no double taxation in this case. You pay after-tax dollars to the bank for both principal and interest. Your 401k earns from the financial market but the earnings have to be taxed when you withdraw from your 401k.
The right hand side represents a 401k loan. Now, if you put an imaginary box in the middle on the right hand side, it becomes exactly the same as the left hand side. You borrow from an imaginary middleman and pay after-tax dollars for both principal and interest. This imaginary middleman then borrows from your 401k and passes the same dollars it receives from you to your 401k. All of a sudden you are not double taxed any more because it looks exactly the same as a car loan on the left hand side. Because this middleman is only imaginary, it follows that you are not double taxed with a 401k loan, whether for the principal repayments or for the interest.
Whether or not you are mathematically better off with a 401k loan depends on how these three rates play out:
- your alternative after-tax interest rate from a bank loan
- what bond funds in your 401k are expected to earn from the market
- the interest rate on your 401k loan
Suppose your alternative after-tax interest rate from a bank loan is 7% and the interest rate on your 401k loan is 5%. If you borrow from your 401k, you save 2% in interest cost in after tax dollars. But also suppose the bond funds in your 401k are expected to earn 8%. If you borrow from it, your 401k plan can only earn 5% from you. So your 401k plan account is 3% worse off in before-tax dollars. Between 2% better off after tax and 3% worse off before tax, it can become a wash. The reason you have to compare it with what bond funds can earn is because the 401k loan payments are not subject to market fluctuation. If you do borrow from your 401k, increase your allocation to stocks for what’s left in the plan.
While there is no double taxation on a 401k loan, there are other negatives on borrowing from your 401k plan. The biggest negative is that if you change jobs (voluntarily or involuntarily), you often have to repay the outstanding balance of the loan within a short period of time, like 60 days. Some plans actually allow you to continue the loan repayment even after you terminate employment, but not all plans do that. If you really need cash and you don’t have any other source except your 401k, taking out a 401k loan is at least better than taking a hardship withdrawal from the plan. Just be absolutely sure you will be able to repay the loan and you won’t change jobs before paying off the loan. And don’t reduce your regular 401k contributions while you are paying off the loan.
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Excellent discussion of double taxation and 401k. I also like how you threw in the bell boy puzzle, that threw me off too.
Anyway, I thought Jonathan made a valid point after I read his article and in fact there is NO double taxation. However, there are still plenty negative associated with taking a 401k loan. Another potential pitfall is that some employers do not allow contribution while you have an active loan. This essentially wipe out your ability to get the matching contribution.
Lastly, you pay interest to yourself when borrowing from 401k so the comparison is not relevant.
Good explanation. I always had trouble trying to convince people of this, especially when they say “Suze said this”. Sigh.
@Pinyo - “Another potential pitfall is that some employers do not allow contribution while you have an active loan. This essentially wipe out your ability to get the matching contribution.” I’ve never heard of that although it has been several years since I last worked in the employee benefits field. When you take a hardship withdrawal, you are required to suspend the contribution for 12 months. There is no such requirement for taking a loan. Making the loan payments while actively contributing to a 401k is allowed. I don’t see why some employers wouldn’t allow it. Do you know for sure some employers don’t allow it or did you confuse it with hardship withdrawals? Some employees voluntarily suspend or reduce their 401k contributions while they are paying off the loan (bad idea). But that’s not the fault of a 401k loan. If they borrowed from a bank, they may find it hard on the cash flow and suspend or reduce the 401k contributions too.
401(k) loans can go either way. I agree that most companies do not stop new deposits while loans are paid off. Recent Kiplinger article cites how much the loan ‘costs you’ but assumed no deposits. The risk in case of job loss is well noted. But the ‘double taxation’ issue is simply wrong as you state. A 401(k) loan can be good or bad but usually it’s clear only in hindsite. Spouse is out of work, bills (CC) got racked up a bit, now spouse is back to work. Using that loan to knock off the high interest CC debt, while the spouse also starts their own 401 account and are both spending responsibly…… you get the idea. There are just too many stories of 401(k) loans gone bad, cards charged up again, etc, in the press.
I used such a loan as part of my home refinance plan, reducing the interest and term of the mortgage, dropping from a jumbo to a conforming loan. The payback for that exercise was huge, despite all the warnings.
Joe
When we start out work for the first time, we believe that we would stay with the same company until retirement and have a comfortable retirement life with all the money we have saved in our 401k account. Unfortunately this does not happen.
Here’s a thought:
it is late March, you are filing your taxes and your preparer asks if you have made any IRA contributions, as doing so would reduce your tax liability.
You respond ‘No, and I don’t have any spare cash!’
I am certain this has happened to many people more than once.
Now if one has the ability to borrow from their 401K plan, why not do so and deposit the loan proceeds into an IRA (either Traditional or Roth)?
You get the tax deduction, and you pay yourself the interest.
At the end of the day, if you use BOTH and IRA and a 401K to prepare for retirement, your overall retirement stash is unaffected.
If a worker has $25,000 in an IRA, and $30,000 in a 401K, borrowing $5000 from the IRA reduces the amount in the account to $25,000.
However, the IRA grows from $25,000 to $30,000 leaving you no better off than when you started. Of course there is the question of how those assets will grow in the IRA, versus the 401K, but this model assumes (roughly) equivalent choices.
There are definite drawbacks, such as loan payments reducing your paycheck (thus further reducing your ability to contribute to the IRA) and the possibility of needing to pay back the loan in a hurry (in case your job disappears).
Furthermore, my own perspective on 401K borrowing is that one should take into account the ‘replenishment rate’ or the time it would take principal, interest, new contributions and net gains to restore your account to where it was before the loan.
But 401K borrowing needn’t be demonized, as long as the money is used productively.
Here is my version:
Put money into 401(k) - not taxed; take money out as loan - not taxed; put the same money back into 401(k) to repay loan - not taxed; take money out at retirement - taxed once and only once.
If you use other money to pay back the loan, it is only slightly more complicated.
Put money into 401(k) - not taxed - and also put money into savings - taxed; take money out of 401(k) as loan - not taxed; pay back loan with savings - not taxed; take money out at retirement - savings taxed for second time. However, the money taken out of the 401(k) was never taxed. There were two sets of money; one was taxed twice and the other was never taxed.
Now here is the real trick. Given that I put money into the 401(k), took it out as a loan, and paid it back, can you tell if I used method one or method two? Does it matter if I used the borrowed money or after tax money to pay it back? No, there is no difference. Each set of money , 401(k) and savings, is effectively taxed once.
But wouldn’t it be better to take full withdrawal rather than a loan for 1st time home purchase? the 10% penalty is waived by the IRS. As your equity grows in the first home it can be transferred into the next home without paying the gain on sale (unless you made a ridiculously great gain). Plus, if the expectation is that by the time you retire, you’re making more money, you’re probably in a higher tax bracket at 59 1/2 compared to lets say 35. So you’re taking home less at retirement.
These comments are just in consideration of using the funds to buy a home rather than to pay down debt.
GB - Actually that’s not true. Your house does not know how much down payment you put in. It will increase in value according to real estate market and generate the same amount of tax free capital gains no matter how much down payment you put in. The extra down payment only reduces your mortgage loan interest cost. In essence you are earning only the loan interest rate. Because a 401k invested in mutual funds is expected to earn a higher return than the loan interest rate, it’s not a good idea to take a full withdrawal from the 401k plan for first time home purchase.
“Also, never ever borrow against your 401k plan because you will pay double taxation on the money you borrow. Because you don’t pay taxes on the money you put into a 401k, when you pay back the loan (which you must do within five years, or 15 years if used to buy a home), you pay it back with money you have paid taxes on. Then, when you retire and take the money out again, you end up paying taxes on it a second time.”
This statement, as posted, is inaccurate. Suze Orman is confusing people with a broad statement that doesn’t portray the whole picture. The loan is borrowed at the same [tax] rate it is re-contributed. The part that is actually double taxed is the interest. This amount does act as a contribution, and rebuild the account with more asset than was removed, but does so after tax, and builds no basis. If $1,000 is borrowed, $1,060 is re-contributed (re-paid). The $60 “interest” grows tax-deferred, and is taxed upon withdrawal. This is such a small effect over time as to be negligible. If the IRS allowed that $60 to become basis in the qualified retirement account, then this would not be double taxed. However, since there are plans out there (401(k)s, etc.) that allow after tax money to be contributed, and to be counted as basis so as not to be double taxed, the IRS is, through tax policy, discouraging people to draw on their retirement accounts early. People who borrow are being forced to add a little more to their accounts through this interest “contribution.”
Question. I have a 403b loan that I am paying off over 5 years. The plan still allows me to make contributions which I am doing, and the interest rate of the loan is variable averaging about 6% over the past 2.5 years. These interest payments go back into my 403b plan as well, basically paying myself. The value of the loan ($10,000) was not removed from my account, but rather placed in a Money Market fund as collateral in case of default or leaving the company. I still earn interest in the 403b on this $10,000 balance, the average being about 2.5% over the last 2.5 years. The money I am using to pay back this loan is in an online savings account that has averaged about 4% over the last 2.5 years.
Am I missing something here, or is this $10,000 403b loan earning me the combined interest detailed above, 6% + 2.5% + 4% (minus taxes on this one) = approx 10%?
In the bad market of the last year, the MM fund has been nice on its own compared to my various stock funds.
Money recontributed, and paid back with “interest,” into a qualified retirement account can actually provide much greater investment valuation potential when the overall market is depressed. Repurchasing shares, or units, at a lower value will net you an incredible increase in the retirement account valuation once the market rebounds. Not to mention you did not cease regular pre-tax deferrals. (Using rounded numbers for simplicity) Your $100 repayment after tax plus your $100 pre-tax deferral are buying shares back at a 10-20% discount, or more. This is the favorable side of dollar cost averaging. Interest was placed in quotes because retirement funds are not allowed, by law, to call it contributions, but that’s what it really is. Your amount set aside that is still earning interest is not only performing better than the market right now, but (case 1) your fund does not distribute the money to you like mine (case 2) does, so that’s another benefit to you. Some will argue that the fund in case 2 is actually lending money from their general pool, and purchasing bonds or other securities to hedge against default, but the effect is the same to the company, so this argument overcomplicates the issue. Put another way: most companies that send you a loan check do not allow you earn the interest on the money placed in a money market account. How much you’re earning, in terms of interest, is not able to be easily estimated, because increased retirement fund valuation is not technically interest. If the market (your aggregate investment allocation)after one year skyrockets to 20% above the previous year - you earned 3% on $10,000 (out of market) plus the amount of shares repurchased during that one year multiplied by 1.06, plus the increased valuation of whatever funds were not removed from the fund.
(Sorry, the paste didn’t work perfectly)
Account value, Jan 1, 2009 $ 20,000
Dollars per share $ 5.00
Number of shares 4,000
Loan $ 10,000
Dollars per share $ 5.00
Shares converted to MM 2,000
Original # of shares 4,000
Shares remaining in acct 2,000
Dollars per share $ 5.00
Value in 403(b) market-linked acct $10,000.00
Acct performance w/loan Value Jan 1, 2009
Amt in 403(b) Money Market $10,000
End of year balance (subtract pmts) $7,692
Average daily balance (ADB) $ 24.24
Average monthly balance $ 737.15
$ 265.37
Value in 403(b) MM acct Jan 1, 2009 $7,956.98
Dollars per share Dec. 31
$ 5.00
Market increase, Dec. 31, 2008 20%
Dollars per share, Jan. 1, 2009 $ 6.00
Payroll deferrals for the year $ 1,200
Shares purchased by deferral @$5 240
Loan repayment amount $192.37
One year’s payments (192.37×12) $2,308.39
Shares repurchased @ $5 461.68
Shares in 403(b) market-linked acct 2,000
Total shares 2,701.68
Value in 403(b) market-linked acct $ 16,210
Total $24,167
Acct performance w/o loan
Value in 403(b) market-linked acct $ 20,000
Dollars per share Dec. 31 $ 5.00
Number of shares 4,000
Payroll deferrals for the year $ 1,200
Shares purchased by deferral @$5 240
Total shares 4,240
Market increase, Dec. 31, 2008 20%
Dollars per share, Jan. 1, 2009 $ 6.00
Total value $ 25,440
A few assumptions were made: 1) The 403(b) is originally a market-linked mutual/institutional fund/account; 2) Interest was posted from the MM acct to the 403(b) as average month accrual; 3) Excel’s PMT function was used to calculate an end-of-period payment schedule; 4) the market fluctuated evenly and consistently enough to yield no increase or decrease (flat) until the last day of the year’s huge increase - not likely, but useful for demonstration purposes; 5) no fees were included - which there always are, so be cautious of these.
Barring any errors in actual calculation on my part, the example above isn’t exactly ahead at the end of the year. But what’s being done with the other $10K in your pocket? Living expenses so that you can defer more annually? Funding business ventures or other investment opportunities? Paying off 28% interest rate credit cards? Really, all of these discussions boil down to “What does your opportunity cost analysis tell you?” These are very individual decisions.
Lastly, to answer the question about taking the money from another investment to pay for this is a wash, unless you consider the reduced balance in that account with interest earning potential. What financial planners will say is that the retirement fund repayment usually comes from your paycheck, so you end up tightening the belt a little - it’s money that once in the bank would’ve been spent anyways. Some will use this as a strategy to keep their paychecks lower, so that themselves or their spouse will not have as much cash to burn through. Kind of a wild and risky sheltering plan, though. SMW
Suze is wrong, but you’re wrong too when you say “there is NO double taxation.” The accurate statement is that principal is single-taxed and interest is double-taxed.
Now you can make the argument that a 401(k) loan is better than other loans because double-taxed interest that you get to keep is better than single-taxed interest that you have to give to someone else, but that doesn’t change the fact that it is in fact taxed twice.
Frank - Read the post and look at the picture again. If the interest rate is the same, a 401k plan loan is *identical* to a non-deductible consumer loan like a car loan or a credit card. If you say the interest on a 401k loan is double-taxed, then the interest on a car loan is also double-taxed. If you say the interest on a car loan is not double-taxed, then the interest on a 401k loan is also not double-taxed. I’ve never heard anybody saying the interest on a car loan is double-taxed.
The reason you’ve not heard people say that a car loan is double-taxed is because it’s not. Double-taxation is the instance in which the same individual is taxed twice on the same money in the same asset pool. This most often occurs in “C” corporation dividend disbursements and when the C corp is sold. I would actually argue that double-taxation does not occur in 100% of the dividend situations either, because the tax rates on corporate net incomes (EBIT) and individual dividends are often much lower than individual marginal rates. I would also argue that double-taxation on recontributions to a retirement account loans is the single most pure form of the imposition of two or more taxes on the same money that most people will experience. Double-taxation is often not referenced concerning retirement accounts, except for debates such as this. Some of the scenarios I’ve debated are that if someone is a shareholder in a bank, and also has a loan with that bank, that car loan interest is double- or triple-taxed. The ownership interests are segregated in instances such as these, however, so double-taxation has not occurred. Also, all members in a credit union are shareholders, so wouldn’t this constitute higher taxation to the individual equity owner? One is a debt collateralized by an asset, the other is a diluted ownership pool only somewhat affected by the member’s loan. Again, two separate interests, two separate investments, whereas the retirement account is solely distributing and receiving borrowed and repaid monies. If anyone could offer a compelling argument that a car loan’s, or similar lending situation, interest is double-taxed, I’d like to hear it. While this is a fun debate, one of the points I’d like to make is that the opportunity costs are more important if all things are considered equal (or close to it). We’ve run simulations that show the comparisons between taking a bank loan versus a 401(k) loan, and came to the conclusions that: 1) even considering double-taxation, if the interest rates of both loans are identical, the net cash available ends up being identical, because the interest recontributed to the 401(k) grows tax-deferred; 2)although I said these debates are fun, the serious component to the discussion is that disinformation such as Suze Orman’s, along with highly publicized blanket statements that are possibly detrimental to a certain percentage of the viewership, needs to be combated by those of us who are most interested in promulgating information that is accurate per situation. Personal financial planning is better individualized rather than oversimplified for mass consumption.
“The accurate statement is that principal is single-taxed and interest is double-taxed.”
Frank is correct, and much more concise than I. - SMW
SMW - Thank you for the detailed comments. I think by this time we all agree that the cash flow for a 401(k) loan is identical to that of a car loan. In either case there will be two taxes: (1) tax on income earned from employment, which provides the source for loan repayments; (2) tax on income earned by the 401(k) regardless whether it’s earned from the financial market or from loan repayments. Like you said “the net cash available ends up being identical.” So there are these two taxes. If you link them directly with no middleman in between, you call it double-taxed. If you separate them and put a bank in the middle, you call it two taxes, but not double-taxed. It goes down to the definition of double-taxation. To me, double-taxation implies a disadvantage. As long as there are going to be the same two taxes anyway, I don’t really mind what you call them, double-taxed, or two taxes.
I believe TFB is signaling that this dead horse has received quite the thrashing. Many sites are not nearly as professional, so I appreciate that from everyone. Good discussion, all. - SMW
Good diagram.
Negating the taxes… Separating the loan from the interest…
Assume you can take a 15k 401K loan out for 0%.
Break the loan into 24 chunks and use it to pay the loan back.
All done.
Easy way to see no double tax.
Use your paycheck to pay that back. Now you start feeling you’re using after tax money to pay it back. It’s a mind game.
double tax on the interest? yes. you’re putting (non borrowed) money into you’re 401k on top of your borrowed amount which will get taxed again when you take it out.
Although interested compounded as a result of that interest payment again falls into the single tax bucket.
Still, take that double taxed interest % and put it into you CC interest instead, you’ll see none of it.
Living the numbers… I took a 2 year loan out in Jan, when news about the recession hit. Used it to pay off all CC. Not necessary, but seemed like the right thing to do.
Now, I just quickly buy back in 401K stock over the next 2 years (401K repayment + Continued contribution) when stocks are lowest.
First year is done. Ride out the bear market next year with more contributions. (Maybe I should have taken out a 3 year loan)
Works for me. I’ll live with the double taxes on the interest (10K @ 6% @ 2yr = ~1200).
Consider middle class family with 2+ kids and a house, after tax income really isn’t after tax. After your deductions, rebates and stimulus, you’re income is practically tax free anyways.
When the market is heading in the other direction, most of Suze’s estimates and projections about how much you could have gotten goes down the drain.
Had I (instead) pop that loan in a reverse index fund back in Jan, that would have been prime. Another shoulda-coulda.