401k Loan Double Taxation Myth

29 Comments on 401k Loan Double Taxation Myth

1. Pinyo on July 30, 2008 | permalink
    

   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.
2. indexfundfan on July 30, 2008 | permalink
    

   Good explanation. I always had trouble trying to convince people of this, especially when they say "Suze said this". Sigh.
3. TFB on July 30, 2008 | permalink
    

   @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.
4. JoeTaxpayer on August 1, 2008 | permalink
    

   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
5. federal plus loan on August 3, 2008 | permalink
    

   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.
6. Peter C, Krieger on August 3, 2008 | permalink
    

   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.
7. ajk on August 3, 2008 | permalink
    

   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.
8. GB on August 12, 2008 | permalink
    

   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.
9. TFB on August 12, 2008 | permalink
    

   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.
10. SMW on August 21, 2008 | permalink
     

    "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."
11. MWS on August 27, 2008 | permalink
     

    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.
12. SMW on August 29, 2008 | permalink
     

    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
13. Frank Rizzo on October 24, 2008 | permalink
     

    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.
14. TFB on October 24, 2008 | permalink
     

    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.
15. SMW on October 27, 2008 | permalink
     

    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
16. TFB on October 27, 2008 | permalink
     

    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.
17. SMW on October 27, 2008 | permalink
     

    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
18. Joe on October 31, 2008 | permalink
     

    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.
19. kevin on November 18, 2008 | permalink
     

    I will not go into a long discussion on the double taxation issue but the interest rate comparisons are somewhat irrelevant because you are paying the interest to yourself. The interest that is applied to the 401K loan is paid back to you so it is not really a loan in the traditional sense because you are both borrower and loaner. Borrowing against your 401K makes more sense than borrowing from a bank because principal and interest all go back to you so you are actually able to put more money into the 401K than when you opened it. The Ideal scenario is to use the 401K "loan" (for lack of better terminology) to pay off debt (e.g., high interest credit cards, etc.) — you save yourself money, pay yourself back at a lower rate and you end up with more money for your retirement (at least that was the hope in a stable market) while minimizing your present expenses. How can that be imprudent or wrong? Keep in mind that Suze Orman's views are biased as she receives monies from many of the same insitutions that created our present financial crisis for which she should receive some of the credit.
20. SageGriot on March 20, 2009 | permalink
     

    This so-called "interest" being paid on 401k "loans" is also a misnomer, IMO. If paying interest to oneself is good, wouldn't a higher interest rate be better? I believe the true cost of a 401k loan has nothing to do with the interest rate and everything to do with the oppourtunity cost. It is important to remember the loan proceeds come from liquidation of assets in the plan (so it really NOT a loan). If the plan sells stock that doubles in value while you are paying back the loan, your true cost is the difference between the stock which would have doubled in value if it had not been liquidated and whatever avererge cost you pay as payments are applied to the account. This is why I always take 401k loans from the cash allocation in my 401k which fixes my oppourtunity cost at whatever fixed rate that account is earning (usually under 5%)
21. The Real Buff on April 18, 2009 | permalink
     

    Sage,
    I agree with your assessment of the lost opportunity cost. Also, remember that 401k's are limited, and only about 1/3 of the plans even offer a fixed income option (and equity index funds don't count as fixed income). The mutual fund industry is going to fight hard to keep it that way, but hopefully there will be some changes. By the way, is Dave Ramsey still assuring everyone they can get 12% in a "good" mutual fund? There is another piker conveniently neglecting to talk about ACTUAL instead of AVERAGE. I digress…

    The 401k should never be used as a borrowing tool. Although, really what you are doing is saying, "Uncle Sam, I need some of that money back that I gave to you to hold, and I understand that I will have to pay you back plus interest out of the money that is left after I pay you those taxes." Many of you are focusing on this whole "double taxation" debate, and you are missing the point. Taking money from your 401k is just plain dumb, with very few exceptions (i.e. you have no options left). It could be argued that just having and contributing to a 401k is just plain dumb, unless you have good match and contribute up to it but no more. You are not really borrowing anything.

    I just generally stay away from any vehicle that has an Internal Revenue Code. The government has clearly demonstrated its inability to manage anything to do with money and anything that has an IRC number was probably not created with MY best interest in mind. If anything, I'd be putting money into a ROTH 401 (before they take it away), but even that is questionable and not too many companies offer it anyway. Does anyone here actually believe they will be in a lower tax bracket at retirement? And who do you think is going to be enlisted to help save Social Security, Medicare, and pay for all this money being created to "save" the economy? I worry about the baby boomers, but also my generation.

    Ask yourself this question… "Do you think that the government would ever pass legislation that would cap the tax rate someone would pay on the distribution of their 401k? For instance, you are in a 25% bracket now, but you would know you would never be paying more than 30% on the distribution? Why do you think the government would or would not do this?

    *And just a disclaimer here, I think Bush was a puppet and Obama is realizing he is a puppet too. I am not talking about left vs right here.
22. kc on June 16, 2009 | permalink
     

    ajk is right except for one point. You do not just pay back the money into your 401K interest free so really the scenario is:

    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 PLUS put the interest owed on the loan back into 401K from your savings which has already been taxed and will be taxed again when you eventually withdrawl it from your 401K. Hence the double taxation.
23. Shawn on September 29, 2009 | permalink
     

    It's true that you are not double taxed on the principal repaid (you take it out and you put it back in with no tax impact on either end). To possibly clarify and agree with kc above, there is double taxation on the interest you pay yourself back with. That is essentially an additional contribution to your 401k account. It is made with after tax dollars, and it is taxed when taken out. Still, that is only a fraction of the amount borrowed and a relatively small price to pay for the flexibility.
24. Geoff on October 24, 2009 | permalink
     

    What it comes down to on the double taxed interest is that you are paying taxes on the interest you have paid back on a 401k loan because you have the interest you have paid whereas if you got a loan from a bank, they would have the interest, not you… therefore, really the only problem with a 401k loan is the potential losing of the job or the loss in market gain of the money current invested in the market.
25. Karen on November 4, 2009 | permalink
     

    If a person is paying 22 to 30% on a credit card and can borrow the money from the 401K at 6%, that is a savings of 16 to 24% . The payments would be from after tax dollars also. On $50,000, that is a savings of approx. $22,954 to 36,304 over 5 years. Which could be used to pay the loan off faster or contribute to the 401k if allowed. This takes a 30 year loan and converts to 5 years. I think that makes 100% sense!
26. Josh schneider on November 5, 2009 | permalink
     

    I agree on the priciple payments, but aren't you still being double taxed on the interest? I am paying interest on the loan, in theory to myself. I am paying that interest with post tax dollars, it is applied to my 401k account balance, then when i withdraw it during retirement, i pay taxes on it again. This is not the same with a bank loan. With a bank loan, i never get the interest back therefore i never pay taxes on it after i initially earn the money.
27. Geoff on November 6, 2009 | permalink
     

    Josh,
    Yes you would be double taxed on interest but realize if you are paying the interest to the bank, they will be getting the money (and perhaps have to pay taxes on it) whereas if you are paying the interest to yourself, you will be getting it and of course have to pay taxes on it.
28. TFB on November 6, 2009 | permalink
     

    Josh and Geoff – As I tried to show with the picture and in the post, if you pay interest to a bank and not take a 401k loan, your 401k money will earn some money from the financial market and you will have to pay tax on such earnings. You are not paying any more tax when you have a 401k loan versus having a non-deductible bank loan.
29. Reggie on November 9, 2009 | permalink
     

    Good discussion. Clarified it for me. I have read the explanations of the hotel puzzle, but I think my explanation is easier than any I have seen:

    Each man pays $25/3 for the room and $2/3 to the bellboy. $27. Its as simple as that.

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