Comments on: 401k Loan Double Taxation Myth

By: Josh B

Josh B — Tue, 23 Feb 2010 06:18:14 +0000

I puzzled over this for a while and found it easier to understand if the problem is simplified a bit.

Consider a $5,000 401k loan is taken out at 0%.

The since the interest of the loan is 0%, the loan can be paid off entirely with the principle that was loaned out. The loan is not reported as income (of course). No taxes are paid on principle loan amount.. Taxes are paid on the principle loan amount only when it is withdrawn from the 401k (after retirement).

As others have mentioned, the interest is another story, that is “extra” money that is paid with after tax dollars. The interest is again taxed when it’s withdrawn.

By: Phil D

Phil D — Tue, 23 Feb 2010 00:17:34 +0000

@Nathan
Very, very interesting. I just contacted my Account Rep to see if this is possible.

As for the naysayers – failing some spectacular market fluctuations, I don’t see how a loan from a retirement account can be detrimental. If you have a good use for that money, such as paying down debt or a worthwhile investment, a retirement account appears to be the ideal way to fund those expenses. The drawback here is that the funds you borrow lose the potential to gain value. However, taking out a traditional loan makes it CERTAIN that your money will lose value (i.e. you WILL pay interest on that money).

I’d rather take a chance at forgoing a few hundred dollars in gains instead of having a 100% chance to PAY a few hundred dollars in interest.

By: Nathan

Nathan — Fri, 12 Feb 2010 01:21:01 +0000

Re: double-taxation of interest paid on 401(k) loans

According to the plan administrator at my employer, interest payments on 401(k) loans are deducted pre-tax (since they are considered “new” contributions to the account) and principal payments are deducted post-tax. I don’t know if this is based on federal rules or if it is just the policy of my plan administrator. Obviously, YMMV.

In any case, thanks very much to the original poster for this insightful article.

By: Reggie

Reggie — Mon, 09 Nov 2009 22:33:37 +0000

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.

By: TFB

TFB — Fri, 06 Nov 2009 22:35:22 +0000

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.

By: Geoff

Geoff — Fri, 06 Nov 2009 21:39:05 +0000

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.

By: Josh schneider

Josh schneider — Thu, 05 Nov 2009 16:13:29 +0000

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.

By: Karen

Karen — Wed, 04 Nov 2009 09:58:05 +0000

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!

By: Geoff

Geoff — Sun, 25 Oct 2009 02:08:20 +0000

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.

By: Shawn

Shawn — Tue, 29 Sep 2009 17:59:47 +0000

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.