401k Loan Double Taxation Myth

I 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. 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:

401k loan

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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  1. Pinyo says

    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.

    • CapinWinky says

      The point about not being able to take the employer match is the biggest negative I can see, A standard employer match is 50% match up to 6% of your salary, which effectively increases your salary by 3%. You could be missing out on thousands of dollars if your plan doesn’t allow the match if you have an outstanding loan.

    • Rob says

      I have yet to see a 401k plan that stopped allowing contributions with a loan outstanding despite being talked about on all the “Don’t borrow from your 401k! articles” but I’m sure they are out there somewhere.

    • Jim says

      There is one thing I’m not sure about. The interest you pay back is after-tax money ($10,000.00 loan, total payback $13,750.00). You’ve never paid any income tax on the $10,000.00, but you already paid tax on the $3,750.00. Is the $3,750.00 considered after-tax funds? If it isn’t, then work the interest money be taxed again when I make my withdrawal?

    • Harry Sit says

      Jim – The interest you pay on any other loan (car, credit card) is with after-tax dollars. The earnings your traditional 401k make from any other sources will be taxable at the time of withdrawal. The two taxes are unrelated. You have to pay these two taxes anyway if you didn’t borrow from your 401k.

  2. indexfundfan says

    Good explanation. I always had trouble trying to convince people of this, especially when they say “Suze said this”. Sigh.

  3. Harry Sit says

    @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 says

    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.

  5. federal plus loan says

    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 says

    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.

    • Bill says

      i know it is 8 years after the original post, but here goes…

      You wouldnt get a tax deduction with a roth IRA.

      and with a trad IRA you save taxes now, maybe 25%, and perhaps pay 15% in retirment when you collect it. a net saving of 10%. which is why I beleive there is a 10% early withdrawl penalty so you cannot cheat the government, you have to wait until 59.5 y.o.

      i borrowed from my 401k to refi into a 15 year mortgage at an interest rate under 3%, saving an estimated $50k. with the loan modeling i did i estimated the 35k loan @4.5% interest paid back to me, would cost about $12k on losing out on market capitolization. so, it was a good investment for me. netting $38k.

      borrowing from your 401k can be a wise thing to do if you understand all the factors. i should also mention that the earlier you borrow in your working career, the worse idea it may be. im middle aged basically.

  7. ajk says

    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 says

    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. Harry Sit says

    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 says

    “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 says

    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 says

    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 says

    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. Harry Sit says

    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 says

    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. Harry Sit says

    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 says

    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 says

    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 says

    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 says

    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 says

    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 says

    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 says

    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 says

    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 says

    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 says

    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 says

    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. Harry Sit says

    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 says

    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.

  30. Nathan says

    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.

  31. Phil D says

    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.

  32. Josh B says

    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.

  33. Tim D says

    Hmmm… paying myself 5% versus the rest of my 401K losing 1/2 it’s value with the recent market fluctuations? I’ll take the loan from my 401K.

  34. EDV says

    Everybody considers the 401k money growing but what happens when the market goes down? I have seen 401k loosing money in the pass couple of years. If you are using the money in some other way and paying it back to you, it is better than loosing it.

  35. SMW says

    See my comment #2: http://thefinancebuff.com/401k-loan-double-taxation-myth.html#comment-862. You’re right – that is a valid point, one which those on this forum will recognize as opportunity cost. The opportunity that is bypassed as a result of borrowing from a retirement plan in a recession is actually favorable, even if you earned nothing on that money (because it’s not generating income on it’s own – you have, however, gained the right to contribute additional, albeit taxable, money to the plan). The opportunity “missed” of losing money – I know, a double negative – was a beneficial one. A huge caveat here is that if you did not pay that money back, so it could earn interest naturally on the huge upturn in 2009, then that was an opportunity lost, this time detrimentally, so it might have been a zero sum, or close to it, game.

  36. Monjon says

    You have to pay tax on any income you use to buy an object. Paying back ‘pre-tax dollars’ with tax dollars simply makes you pay income tax on the object you borrowed the money for. You’d pay it that way if you have a bank loan, a mother-in-law loan, a home equity line of credit, or a 401(k) loan.

    Period. End of story.

  37. SMW says

    Unfortunately, that argument is nonsensical. The reality is actually that when the income is earned, income tax is paid. What occurs with double taxation of loan interest recontributed to a retirement plan is that money to pay the interest back is coming “out-of-pocket” as we say in the retirement plan industry. It has already been taxed once, to that individual. When that interest is placed inside of the plan, for instance a 401(k), which is money that has not been taxed, it will therefore be taxed at your ordinary tax rate upon withdrawal. Since that small pocket of money (remember it was already taxed once) is indistinguishable from the other plan assets, upon withdrawal it will be taxed, as I said, at your ordinary rate. It would be possible, but unlikely, that a 401(k) could have 10% of its balance comprised of already-taxed loan interest, and 90% from untaxed earnings and contributions, but it’ll work for this example: upon withdrawal, the 10% already taxed and the 90% untaxed will be taxed indiscriminately, at what is often a higher ordinary tax rate than one pays while working because of fewer write-offs at retirement age. Retirement plan loan interest double taxation is a fact, and not a myth. In the tax accounting realm it is known as one of the social economic policies of tax law: the IRS is going to let you use money in your retirement plan prior to retirement age, but they’re going to offer a slight disincentive for you to do so: they get more tax money from you because of it.
    Check out Line 15b of your Form 1040 and realize: if any money that has already been taxed (401(k) loan interest) winds up on this line in retirement (which it will if you paid loan interest into a retirement plan), you’re a victim of double taxation. Take it from a tax accountant that this is no myth. By the way, all of the examples of bellboys who can’t count, credit union, bank and mother-in-law loans have nothing to do with taxation, and certainly not double taxation. I realize you’re trying to explain the overall effect of a group of people and companies, but taxation is very individualized to a person, family or business entity, and therefore the aforementioned examples and explanations are irrelevant and misleading. A bank loan does not get taxed again (just once upon repayment, amortized from your paycheck). A mother-in-law loan does not get taxed again. A home equity line of credit does not get taxed again, and in fact is tax advantaged, giving you additional write-offs. Not that that’s a great reason to hyper leverage your potentially largest asset, but these decisions are unique to the individual. Speaking of decisions: I really hope that those of you drawing the useless diagrams, giving inept examples, and claiming to (inaccurately) be experts (“Period. End of Story.”) on subjects like these are not using this misinformation to steer clients, friends and family the wrong way. What has been bandied about has been opinion, but opinion has no place in cut-and-dried matters of tax and retirement law such as these. Not that subjects like these are all that serious, but it can evidence a personality trait of continued misinformed misdirection, which could eventually lead to a cause of action from one or some of those you have advised. Is your Errors & Omissions insurance up to date?

  38. Harry Sit says

    @SMW – I thought we settled it two years ago in comments #14-17. With regard to loan interest, you call it double-taxed. I call it two taxes, unrelated to each other. As long as people understand there are these two taxes whether they borrow from a 401k or borrow from a bank for a car loan, I don’t mind what it’s called. After all, double is two, two is double.

  39. SMW says

    Sorry, TFB. The comment was actually to Monjon who replied on the same date as my recent post, which was a reply to EDV. Double taxation is the correct technical term, not something I made up, and it is directly related: income taxed once, then taxed again in retirement, and in the same retirement plan. The beating of the dead horse was just for clarification – prob got a little carried away. I hope it wasn’t rude. And just because I can’t help it: you are not taxed two times on loans from banking institutions, and other individuals. Only on retirement plan loans, i.e.: 401(k), 403(b), 457(b) plans. And if you withdraw early from the 401(k) and/or 403(b), there’s not only a double tax on the interest portion, but also a 10% Sec. 72(t) penalty on both the taxed interest and the untaxed funds, but I digress.

  40. Harry Sit says

    @SMW – The interest you pay into the plan is replacing the interest the plan account otherwise would earn from the financial market. If you get a loan from a bank, you are also taxed twice: once on the income earned to pay interest on the loan; again on the money the plan account earns from the financial market because the plan account didn’t loan out the money to you. You don’t escape any taxes by borrowing from a bank.

  41. Still Confused says

    An employee contributes X amount of money directly from employer’s payroll pre-tax into 401k. The, employee takes out $1,000 (though amount is irrelevant) loan from 401k. The loan is a pre-tax distribution. The employee then, makes after-tax payments on the 401k loan through direct deductions from payroll. Therefore, the employee is paying taxes on the 401k loan repayments contributions into the 401k account.
    Employee leaves employer while loan is only 50% paid off. The employee opts to rollover the 401k balance into his new employer’s 401k. The remaing loan balance is deemed, the amount is deducted from the total balance before rollover and the employee receives a 1099 to claim as income on federal tax income, thus paying taxes on it.
    Employee retires. Employee takes distribution from 401k. The distributions will be taxable.
    My question is: If the employee is making after-tax loan payments into the 401k and then, upon distribution must pay taxes on the amount, then isn’t that double taxation? Or does the 401k institution separate pre-tax and after-tax (loan repayments) contributions when reporting 1099’s?

  42. MES says

    I still don’t get it. My loan is not supposed to be taxed because it is not considered a distribution. BUT I repay it with AFTER tax dollars. THEN when I retire, I pay tax on that same money. I know it’s not a good idea to borrow from a 401k, BUT…it’s done, so…
    It kind of reminds me of the rule of paying tax on tuition reimbursement which was then reversed since it was also determined to be double taxation. And it was. Aftertax dollars were spent on tuition and then when reimbursed by the company, the IRS was stating that it was income when it was NOT. Same with the 401k as I see it. If it’s NOT supposed to be taxed, then repayment should be made from pre-tax dollars.

  43. Ancient says

    Lets use Roth 401K example and it will become more clear:

    You contribute $10 to the roth 401k with after tax money, you take a $10 loan out tax free. You repay back $10 (+ interest) to the account with after tax money, and eventually you’ll take the $10 (+ interest) out tax free when you retire.

    No double taxation there, right? By taking the loan you just moved the money around in the cycle two times instead of one.

    Now substitute this scenario with a pretax 401k:

    You contribute $10 to the 401k with non taxed money, you take a $10 loan out tax free. You repay back $10 (+ interest) to the account with after tax money, and eventually you’ll take the $10 (+ interest) out taxed again when you retire.

    A little more complicated, but you can see $10 has never been taxed at all, and $10 (+ interest) has been taxed twice. $10 cancels out and is taxed only once, and (+ interest) is taxed twice.

    Should interest be taxed twice? It is not a transaction between two parties, there are no profits being made when you put more money into your own account, I don’t think interest should be taxed again when you retire…..

  44. regor60 says


    The original money you contributed was from income that wasn’t taxed. When you paid back the loan you took, you paid it back from new income that was taxed, as you’ve said. The reason you’re paying taxes on the income to repay the loan is because it is not a “new” contribution. A loan from a 401k is booked as an investment of the 401k and is called a “loan fund”. So your original investment just changed form. As you pay off the loan, the balance of the loan investment of the 401k is reduced dollar for dollar. The net balance of the 401k only changes to reflect the interest on the loan.

    Yes you do pay taxes on the original contribution you made, but that is only because you didn’t pay them up front. The loan you took has nothing to do with this.

  45. Amy says

    So I liked this part: ” The interest you pay into the plan is replacing the interest the plan account otherwise would earn from the financial market. If you get a loan from a bank, you are also taxed twice: once on the income earned to pay interest on the loan; again on the money the plan account earns from the financial market because the plan account didn’t loan out the money to you. You don’t escape any taxes by borrowing from a bank.”

    This says it all.

    My scenario: Contribution to 403(b) plan. Money was in various Fidelity plans. Market begins to tank. I move it all into a Savings fund that is still in my 403(b). I accrue interest at about 1% or less.

    I have a car loan with a 12% interest.

    So… my car loan was a 5 year loan and my monthly payment is over $300 a month. This cuts me short of money every month. Plus, at 12%, my loan will cost about $4k more at the end of the term (or something like that).

    So I take out a 403(b) loan. SAME exact 5 year term. My MONTLY payment is literally halved. This means I am more comfortable with my monthly living expenses. This means I can take out MORE pre-tax (not matched) contributions. The cost of my loan at the end of term ends up being a 1/3 of the original loan.

    I am paying myself back at 6%.

    I would have been a fool to not borrow from myself.

    See, there is MUCH more to balancing your life than just an Excel spreadsheet. And it’s clear to me that because there is NO definitive answer on this and many, many interpretations, it’s not black and white.

    See, I am earning 6% on my money. If I were to put the same money in a regular savings account today, I would earn. .00000001% or something like that. In other words, my after tax dollars have ZERO ability to earn interest other than an unpredictable stock market.

    And for the subjectivity: So maybe the same after tax money could earn more in the market (after tax). A) I would have to know what to do B) where to invest C) have the financial fluidity to risk possibly LOOSING the money.

    I am not hugely financially savvy. I cannot take any stock market risks.

    So in this scenario, the answer to the question is not just what it looks like in Excel. The answer depends heavily on multiple circumstances and factors.

    In My case:

    Needed to reduce my monthly after tax bills or risk accruing more debt
    Needed to continue to contribute to my 403(b)
    Needed the safety of returning my money to a financial management situation that works for me.
    Needed for the cost of the loan to be halved.

    How, in all of the double taxation talk, can you work this into that language? I don’t think you can.

  46. BP says

    Let’s say you have $50,000 in professional student loans at an interest rate of 6%. (I know of no way to get a lower interest rate.)

    It then makes sense to borrow $50,000 from your 401(k) assuming the following:
    1) You continue making savings contributions while the loan is still outstanding.
    2) You feel certain that you will not leave or lose your job for duration of the loan.
    3) You consider a fixed return of roughly 6% to be an acceptable investment.

    Anything I am missing here?

  47. R Cole says

    There is a fundamental flaw in the example used here: In one case the loan comes from a bank (money is not yours), in the other case the loan comes from ones own 401K account, (money is yours). The example is thus an ‘apples and oranges’ comparison.

    There is a ‘double taxation’ with a 401K then because the money (your money) used to repay to loan has already been taxed as income. That already-taxed money icommingleded with the before tax money but there is no accounting of that – so when the money is withdrawn at retirement is all subject to income tax. Thus the after-tax dollars that went into the 401K are taxed again. That portion of the disbursement is double taxed.

    By the way, the cute story has nothing to do with this situation.

  48. Joe says

    Still? You don’t have to use taxed money to pay off the loan. Quit thinking that. You have a pile of untaxed money at your disposal.

    You took out un-taxed money. Just imagine you using that money to pay back the loan and it will make more sense.

    theoretically, when you pay back what you take out, what’s left, (interest) could be paid with taxed money, which will get taxed (a second time) when taken out.

    then again, even that interest doesn’t have to be paid with taxed money. you’re untaxed money taken out can bring in untaxed income if you stick it in a roth and take it out after retirement.

    make sense?

  49. jeff says

    Can I use funds from an older 401k to pay off a loan in my new 401k. Rolling over the money inside the 60 day grace peiord and pay off the loan at the same time.

  50. David says

    SO nice to find a guy that gets that the whole “double taxation” thing is bunk! I try to convince people of this, and they never get it.

  51. Wilson says

    very interesting discussion here. After reading most of the post, I think most people here agree that the principal paid back to the 401k loan is not “double taxed”. The real tricky situation is only on the additional interest paid to the 401k account. One thing to keep in mind is that any interest earned within your regular 401k account will be taxed anyway whether the interest is paid by you or your 401k account earns the interest by itself.

    To simplify the problem, let’s forget about the principal payment and just focus on the interest payment. When you pay interest payment(after income tax dollar) to your 401k and that interest payment is taxed when you withdraw at retirement, you certainly “feel” that it is double taxed.

    However, if you pay that same amount of interest payment to a bank(just like any other you loan you have), then that bank deposits that same interest payment to your 401k(assuming your 401k account lend the principal to that bank as an investment), then your 401k will earn the same amount of interest you pay to the bank. Remember again, any interest earned within 401k will be taxable, so you will need to pay tax on that interest payment earned by the 401k. Comparing to paying interest directly to your 401k yourself, you are now in exact same financial situation. However, do you still “feel” being double taxed?

  52. Harry Sit says

    @Wilson – You got it! That’s exactly what I tried to show with the picture. There are two taxes. Some say it’s double tax. I say it’s two taxes, unrelated to each other. The bottom line is exactly the same though.

  53. dd says

    Agree with this analysis, as one is paying any mortgage or loan back with post-tax money. But this should not be so, as pre and post-tax contributions can be made to a traditional 401K (depends on employer). When the 401K money is distributed, taxes are not paid on the post-tax portion of money and distributions are taxed proportionally. Earnings on both pre and post-tax earnings are taxed. Paying back a 401K loan is in reality exchanging pre-tax contributions with post-tax contributions.

  54. Harry Sit says

    @dd – It should be so. The loan payments are merely replacing the money taken out of the plan account. If the loan money came from the pre-tax bucket, the repayments have to go back to the pre-tax bucket. Otherwise I would just take a loan, immediately repay it and shift money from pre-tax to post-tax. Same goes for the loan interest. Since the earnings in plan account will be taxed without the loan, the interest it earns from the loan has to be taxed as well.

  55. Josh B says

    @TFB – Perfect simple explanation for the non-interest part. I don’t see why there’s so much confusion on this.

    Strictly speaking, i would say the interest is double taxed from the perspective of the 401k owner. You call the interest payments earnings of the 401k plan, but someone else could just as validly argue they are non-standard contributions. I think the interpretation is arbitrary in that the law could have been written either way. It’s not a surprise that it’s written to maximize government revenue.

  56. dd says

    Josh B, I agree with you that this area could have a number of interpretations: this is probably why there is so much confusion. Somehow the current interpretation does not seem intuitive, but does maximize government revenue.

    I am not a fan of Suzy Orman and prefer the Jane Bryant Quinn. Although Suzy Orman’s recommendations are not always 100%, most of her recommendations follow generally accepted financial concepts. She has simplified and popularized financial literacy to the benefit of many.

  57. John Monahan says

    dd’s point stated extremely well, and I have to agree. While both Suzy O. AND Dave Ramsey have brought some semblance of basic understanding to the masses, one has to recognize that their aim is exactly that – ease of understanding to the masses.

    One example of this point: both laud the benefits of using the Roth IRA. Having been in financial services myself, I have a basic disagreement about the Roth products, but for the general public – especially those who are currently not saving at all – the Roth is a an easily understandable way to save money with expected tax saving benefits. Is the traditional IRA, 401(k) or 403(b) a better choice? In my estimation, yes, but probably a discussion for another forum. However educating a less-than-sophisticated group of new savers (particularly en masse and by popular media) can be a long process which can and does eat up precious saving time. Here the time honored, “Time is money” is precise and to the point. Get ’em saving is paramount.

  58. Harry Sit says

    @Josh B, @dd – Loan interest and contributions are different concepts. Loan interest comes from time value of money. If you are replacing $100 pretax money a year from now, you have to replace it with $105 because of time value of money. The extra $5 isn’t a contribution.

    Suppose both you and your co-worker are borrowing the same amount on the same terms but you are borrowing from her account and she’s borrowing from yours. The cash flows from your pockets and to your accounts are identical with a regular 401k loan. Your accounts don’t care where the money comes from and you don’t really care to whose account you are repaying. You got a loan. You are paying interest. That’s all. You are not making a non-standard contribution to her account. You are paying interest to compensate her for the time value of money. Of course she should be taxed for that. It’s the same when you and she are the same person.

    The public wants a simple, black-and-white solution for their money questions. Suze Orman fills that need. A consultant to financial planners lamented that all the CFPs in the country added together don’t have as much reach as three mass marketing gurus: Suze Orman, David Bach, and Dave Ramsey. It’s the same as McDonald’s. It’s fast, cheap, and it serves far more customers than white-table-cloth restaurants. If you are hungry, McD’s will do. Just don’t eat there every day.

  59. SMW says

    @John Monahan – I agree on your point concerning Roth IRAs, especially when anyone proclaims: “everyone should have one” or “the only account you need is…” And to the other comments: maybe we should apply the 80/20 rule to financial planning talking heads – take 80 percent at face value, and view the rest with raised eyebrow.
    @dd – If I’m understanding your complaint correctly, you wish that it would be allowed for your interest paid to be allocated to the pre-tax portion of your retirement account. I think you’re spot on. TFB, I get your point that the interest is replacing what would otherwise be earned in the markets (at least that was Congress’ intent when they allowed plan loans), but its future value, and potential, is the same as contributions, so even those of us in the plan administration field do view it as similar to another type of contributions – earnings. They are contributed by the markets. The account balance and it’s taxable value are the concerns. This is one of those social policy issues, where Congress’ other intent was to mildly discourage borrowing from retirement plans: to tax those post-tax, out-of-pocket loan interest payments. But again, the effect of that tax is so minor, really percents of percents, that, as we’ve agreed in this “forum” in the past, should not be a deterrent to borrowing against your retirement plan funds if you have greater investment/savings opportunities elsewhere (doesn’t stop me, and I’ve designed plans!). @TFB – while I don’t agree with you on everything, I think your website and the discussions it engenders are great. You attract people online who really are interested in becoming financially educated.

  60. John Monahan says

    @ SMW – In some cases, there should be a 99/1 rule – I worked under one of those…

    I have many reasons to dislike the Roth. As I said earlier, I would only use it as a position of last resort. I believe in filling up the bucket no matter what bucket the client prefers. I may take my best shot at educating them, but quite frankly (and I’ve run into this several times) they want a Roth no matter what, usually because their ‘investment guru’ (translation – the guy in the office or a friend talks like he knows what he’s doing financially…) told them the Roth is the best thing since chewing tobacco. Sigh – ok – at least they’re saving/filling the bucket.

    My main concern with the Roth (and frankly in today’s political climate a lot of other things) is the ability for the govt. to change directions at any point they see fit. You only need point to a social program, started in the 1930’s with no taxation on benefits, that 40 years later began taxing those same benefits. You know the one I’m referring to – SSI. So is it far fetched to think the Roth proceeds could be taxed? Maybe. Is it possible? You betcha.

    Lastly – your encapsulation of the miniscuilty (is that a word?) of the tax consequenses should be in a text book somewhere. Excellent summarization. I have accessed funds from 403(B) accounts for my wife and I and we’ve saved thousands and maybe tens of thousands of dollars in interest payments. May have cost me a couple of hundred in taxes, but I’ll do that all day every day. Thanks for the concise description.

  61. Dean in NY says

    You are misleading people with this article. Yes you are not getting double taxed when comparing it to a credit card or non-tax deductible loan. But 401k loans in general are NOT tax deductible. So those of you borrowing from it to invest in something else (IRA) are losing doubly because they cannot deduct the interest they are paying. Even credit card interest is deductible when used for business or investment purposes. 401k interest is not deductible under these conditions. If you do not believe me, try to do this. It will take about 3-5 years for the IRS to catch it and catch up to you, and when they do.. look out!

  62. Steve says


    Lets say someone contributes 5k yearly to their 401k. December rolls around and they want to add 5K to their IRa. Being that the 5k in the 401k is pretax, if they take a loan out for 5k can they now deduct 10k from their taxes? It would be a win win.. they are really only placing 5k yearly into their retirement acct, yet they are deducting 10k for tax reporting purposes. Also they are giving themselves guaranteed return on their 401k.

    Thoughts on this.. im sure there is no way this would work but curious to see what others think.

  63. SMW says

    @Steve: You can do this, but it might be counter-productive, or at least unproductive. This might be a good idea in a bear market, and you have no better use for that money, but since it is a year after you could have been contributing, the opportunity cost is a little high, IMHO. You could have been contributing regularly to the IRA all during the past year, using the concepts of dollar cost averaging (DCA) and compounding. These concepts don’t always work in our favor, however, with 2011 as a good example: when a market ends the year at roughly the same point it began, with values increasing during the year then reverting back to the mean, you can actually lose money on a DCA basis. I find it hard to time markets with loans, and the risk, mentioned below, is a little uncomfortable for me. I think there might be better places to invest, but at only $5K, that risk is relatively low.
    You also bear the risk of leaving the job of the 401(k) sponsor, and not being able to pay back the loan immediately, triggering both the 72(t) early distribution (10%) penalty and income taxes on the amount not repaid to the 401(k). If your plan charges fees for loans, that may be a detractor as well: remember, once you start doing this, you might keep investing like this on an annual basis. If it’s a one-time deal, it’s probably relatively harmless. If it becomes a long term pattern, you could be eroding your investment basis through fees, and paying yourself a minimal return in many bull markets over your career.
    I’d say instead, start investing habitually.

  64. Billy M. says

    Here’s a brain tickler:
    Joe puts 1000$ into traditional 401k back in 2009. Company matches the 1000$. His current tax bracket is at 15%. He has 2000$ in the account.
    Joe takes a 401k loan for 1000$ in January 1, 2011 at 5% and pays back the loan, 1050$, later on in the year Dec 31, 2011 at the current tax bracket 25%. The 50$ is now taxed at 25%.

    The way I see it, the 401k loan will eventually force you to lock more money into the traditional 401k, that will not get matched and is taxed at a higher rate. If you have to do it, do the smallest amount you need to. If you start playing in the 10,000$ loan, you’ll end up having to put 500$ at 25%. Money that can be better spent elsewhere.

    The way I was taught is the following: put $ into 401k up till match contributions. Max out ira because of versatility and availability of funds/stocks. After you max out roth, put more money into 401k or another vehicle providing better yields.

    I was also taught to put money into Roth versus traditional, mainly because when you start making distributions, you’d most likely be in the late 60’s early 70’s. At that time, most of your deduction capabilities will be gone, and you will still need to survive on some level of revenue… and if it’s traditional, it will be taxed.

    Right now many who are contributing to their 401k is probably around the 25% tax rate. Many plans enforce an income tax rate of 20%. So regardless, that 25% tax above for the 50$ is working against you.

  65. Billy M. says

    To clarify, I understand that you will end up having to pay the 25% on the 50$, but instead of wanting to, you are now obligated to.

    In terms of loans, this is a good type compared to any of the other private bank loans.

  66. Matt B says

    This is absolute crap…. There is absolutely double taxation on loan payments back to a 401k.

    True, it’s not tax deductible…but you’re making the payments with after-tax dollars. When you withdraw the funds at retirement – the entire balance is taxed, including those after-tax loan payment dollars.

    The author threw in a bunch of pointless examples of other types of loans you pay back with after-tax dollars, but it all comes down to the above.

    Double taxation on 401k loan PAYMENTS is not a myth.

  67. Billy M. says

    No. You are incorrect. Only interest incurrs DOUBLE TAXATION if and only if you have traditional (pre-tax) 401k. This will include, company matching, and any pre-tax contributions.

    If you have a traditional 401k and you borrow (not withdraw) let’s say 1000$. At that moment you get 1000$. That 1000$ has never been taxed, ever. When you put the money back in, you are putting that 1000$ back in + interest. It’s relative. The interest however is paid with after tax money at your current tax bracket. When you finally retire and start distribution, the interest is then taxed again upon distribution.

    However, if you have a Roth 401k, it is not taxed again upon distribution.

    Like I mentioned above, you are forced to pay tax at your current tax bracket for the interest. This could mean you are at 25%, or maybe even 35%.

    Unless you can get a 0% loan indefinitely, a 401k is the best choice unless it’s for a house, which in that case, I’d prefer you take up their mortgage loan.

    Case: Let’s say your account has 60% roth 401k and 40% matching (pretax) contribution by your company.
    You still have to pay back the principal + interest for both, but when you retire, 60% is not double taxed, the other 40% is.

  68. John says

    I think the best way to explain the missing dollar problem.

    30 (10 dollars by each man) = 25 (amount kept by hotel) + 3 (1 dollar for each man) + 2 (kept by the bellboy)

    Still trying to wrap my head around the above posts.

  69. dave says

    I’ve always thought the same thing, Suze is theorizing and not being mathematical. Another basic case is if you have some 20 percent credit card and carry a balance of lets say $5000, so you’re paying $1000 a year (ballpark) in interest…instead you take a $5K loan from your 401K, you pay yourself back 4-5% interest and you pay off your CCard. You’ve just saved $1000 a year in interest and while you did have to pay the interest to yourself ($250), you did not lose that money, it’s back in your account. Now multiply this time some number of years (considering the ccard balance is going down) and you find that you have likely saved at least a couple thousand bucks. And if you didn’t pay off the ccard with the 401k loan, well you’d be paying the credit card off with AFTER TAX DOLLARS. You’re always paying stuff off with after tax dollars, so it is a moot point. Not to mention that she and others are always saying, oh but you won’t be realizing those 401k gains…they never say …losses. You can just as well have saved yourself some more $$$ by taking $$$ out from your account before the market went down.You just don’t know. Bottom line: taking out a 401k loan is a great idea as long as you use it for a specific purpose and don’t get too used to it. and of course be sure you have the fund to pay it back either in bulk (if you get fired and the plan doesn’t allow monthly payments anymore) if you have to cuz you dont want to get swatted with a withdrawl tax + 10%.

  70. dave says

    best way to look at this is this:

    you put $1000 pre-tax money in a 401K
    ..eventually you are going to pay a tax when you make a withdrawl

    you take out a $500 401k loan….you will be paying yourself some interest (like 4-5%_

    3 months later you pay off the $500 loan ..yes you are using ‘after tax money’ to pay if off
    but you’re using after tax money to pay off any loan

    you pay off the $500 401K

    when you take out the $500 401Kk money, you pay taxes..just like you were gonna pay taxes on it if you didn’t take out a loan at all.

    …so in theory you paid off your ccard with ‘before tax money’

    there is no double tax… you are paying tax on the 401K loan with some dollars, the fact that the dollars you have in your pocket that you were already paid tax on means nothing.

  71. Vinod Sindhu says


    All of you are missing one part.

    Lets say you borrowed 500 from 401K and paid back 550, here $50 is the interest on which you have already paid taxes. Now when you will withdraw this $50 after retirement again you will be paying taxes on it. That means you are taxed twice on the interest you pay on the loan from 401K.

  72. Harry Sit says

    Vinod – If you didn’t borrow from the 401k account, you would still pay tax on your salary (tax #1), the money in your 401k account would still earn something from somewhere and you would still pay tax on that earning (tax #2). You are taxed twice regardless. Double taxed implies you pay an extra tax if you borrow. That’s not the case.

  73. Dana says

    As far as doule-taxation, I may be dense but I don’t understand these arguments. Suppose I take a $10,000 loan for 4 years and payback $50 a week.
    That’s $2600 a year x 4 years = $10,400 – after taxes. When I retire and withdraw that $10,400 I’ll have to pay taxes on it. How is that not double-taxation? If I put that same $50 a week in without taking a loan that $50 only gets taxed when I withdraw it.
    To say that I have to pay back any other loan with after-tax dollars or the money wasn’t taxed when I originally put it in are not valid arguments and doesn’t even pertain to the situation.

  74. Joe says

    Take your 10,000 (from the tax-free 401k loan) to pay back the 10,400.
    Your “first” tax on the 10K never occurred because it’s from a non-taxed source.
    If the 400 is from a taxed source, then it will be double-taxed on removal.

    It’s a silly loan to make but illustrates that you have (temporary) access to tax free money when you take a loan from a 401k.

  75. Mark says

    Agree that payments made to any loan are from already taxed income. That puts all loans on a level playing field for the “first” tax. The principal amount I pay back can be counted as if it was originally drawn out of the 401K trom originally tax free contributions so there is technically no “second” tax on those amounts.

    However, there is a “second” tax on the interest that I pay into the 401K because when I withdraw that money later I pay taxes on it. The interest I pay back was not withdrawn from the 401K which means they are being paid from previously taxed funds..This counts as a “first tax” on those payments. This is the big difference that is being ignored in the “no double tax” argument – that you will later draw the payment funds back out of the loan source and pay taxes on them. You cannot do this with a regular loan so there is no possibility for a second tax event.

    So the double tax statement is not completely wrong nor is it completely right. The weighting depends on the ration of interest to principal paid.

  76. Harry Sit says

    Mark – “You cannot do this with a regular loan so there is no possibility for a second tax event.” With a regular loan your 401k assets are untouched and therefore it will grow a little more. You will pay tax on the extra earnings. That’s your second tax event.

  77. Joe says

    This blog seems to argue that in some indirect way, there is ultimately a detrimental tax-like effect on you from a bank loan because a bank would have to pay taxes on a loan to you and this eats away at how much the bank can invest in the financial markets that your 401(k) is based on, or something like that. I think that in reality, the direct tax on your interest on lending yourself money from your 401(k) is more likely to have an actual economic effect on you than some indirect detrimental economic effect on your 401(k) from borrowing from a bank, whether or not you want to call it double-taxation.

  78. rob says

    OK, I have a 20,000 loan for 10 years at 6 %. I have a goverment 457(b) which I understand means I am not subject to the 10 penelty for early distribution.

    Why not default on the loan (my money) and pay the tax now. Use the emaining funds to pay off CC debt and take the money I would have been paying back to the loan and put it in a Roth?

    I have a pension, and with our debt, I do not see tax bracket change when I retire dut to taxable pension.

    I must missing something as I see no discussion of this anywere

  79. Paul says

    Isn’t it better to over-contribute to a 401K and take a loan if needed rather than over-contribute to a savings account and just spend the money from savings if needed? If nothing happens (car repair, appliance replacement, etc.) then I get the added benefit of a larger 401K right?

    So if I would normally contribute 5% to my 401K and 5% to my rainy day fund (savings account), why not contribute all 10% to the 401K and then borrow within that extra 5% for unexpected big ticket items?

  80. Harry says

    Paul – A 401k loan usually has a setup fee to the tune of $100. It also takes a week or two to get. If you use 401k as an emergency fund, it has to be for something major, not just replacing a dishwasher costing $500. After you have a few thousand dollars in a rainy day fund, the 401k loan can certainly serve as a 2nd tier as you described.

  81. Holly says

    I want to make sure I have this write. I have a 401K loan. My contribution are taken out pre-tax, however my loan payment is being taxed (according to the federal taxable wages section).

    I called the IRS to find out if the payment was supposed to be taxed and they told me that my employer should be consistent, meaning that since the 401K contribution is being deducted pre-tax then the payment should be pre-tax also.

  82. Harry says

    The IRS agent you spoke to was mistaken or misunderstood your question. The loan payments are after tax, just like your loan payments to any other consumer loan, like a car loan or credit card loan.

  83. Holly says

    Thanks Harry. I believe the agent thought I was referring to a one time distribution vs. a loan that was not assigned a penalty.

  84. Phil says

    But the interest you pay on the 401k loan is actually a contribution to the account, and should be pre-tax. Under my payroll, it is not. This is a very small amount of money, but technically it is a new contribution and not a repayment of the loan. Right?

  85. Harry says

    Phil – The interest is not a contribution. It’s your money’s earnings, just like the earnings your money gets from mutual funds, except this time it’s getting the earnings from you.

  86. Holly says

    this is where I get a bit confused. The concept of the loan repayment, whether it be a normal consumer loan or a 401K I understand, if the payments were solely being applied to the loan but if the loan payment is increasing my 401K balance isn’t that a contribution back to the 401K? I went back to the loan documents and it doesn’t state either way if it would be considered strictly a payment to the loan or a contribution to the plan.

  87. Holly says

    who governs these rules? Is it the IRS or the plan administrator? My issue now is that my employer wants to provide me with an amended W2 for 2010 and 2011 and I would be responsible for amending my taxes, but if there was not a clause in the loan documents about how the loan payment should be/have been applied should I have to file an amendment?

  88. SMW says

    @Holly: a 401(k) loan repayment does not alter contributions credited to your account each year. Ex: your $1,000 in loan payments in a year does not impact your ability to contribute up to $17,500, regardless of how much of that payment is principal or interest. Unless some portion of what you borrowed is being considered a withdrawal, or is deemed, I do not understand why your plan administrator is trying to amend W-2s. Except in case of errors, I’ve not seen amendments in W-2s regarding plan loans. BTW – it is the IRS, not the administrator who governs plan loans, and here’s a link (scroll down to the bottom): http://www.irs.gov/Retirement-Plans/Plan-Sponsor/401(k)-Resource-Guide—Plan-Sponsors—General-Distribution-Rules – Sean

  89. Harry says

    Holly – The IRS sets the rules. If your employer mistakenly took the loan payments pre-tax in previous years, then they should give you amended W-2’s showing more income and you should amend your tax return and pay the tax that you should’ve paid back then.

  90. Josh says

    You are double taxed on the interest you pay. First when you earn it and put it in, later when you take it out. That’s double tax plain and simple.

  91. Claire says

    What are you all talking about????? 401 K loan repayment is double taxed, period. It’s does not matter who contributed to your 401K: you, your employer or John Smith, it’s your pre-tax earnings and you will pay taxes when you get retired. If you borrowed loan from your 401K it’s not tax deducted, so you should pay it back not tax deducted; otherwise you repaying your loan by already tax deducted funds, and later, when you’ll retire you will pay taxes again. Does not matter what interest or no interest your plan will make, it’s your plan earnings(that is what 401K plan for…) and you will pay taxes on all that money upon retirement. Don’t compare it with car loans, mortgages and other…that is the different things… 401K is simple math: you borrowed loan from 401K and repaid it back with your money where taxes already taken, and upon retirement you will pay taxes on all 401K money again: SO YOUR LOAN AMOUNT TAXES WOULD BE PAID TWICE.

  92. Vince Wagner says


    I appreciate your article but you leave out one major detail. You ARE double taxed on a 401k early withdrawal because UNLIKE a bank loan, inwhich you DO NOT have to claim it as adjusted gross income, you DO have to claim a 401k loan as adjusted gross income. Because of this I was put into a higher tax bracket, and subsequently paid a much higher tax rate.

    As an example, IF I borrowed 50k form the bank, I WOULD NOT have to claim this as AGI, however, I actually borrowed this same amount from my 401k in 2012 and had to pay an additional 10k on 50k additional taxable income. Now ( in taking the repayment with post-tax dollars discussion off of the table entirely ) that SAME 50k ‘taxable income’ will also be ‘taxed again’ when I withdraw at retirement.

  93. SMW says

    @Vince – since I am a tax pro, I am in the “double-taxed” camp, and have posted to this forum several times, but must encourage you to make sure your taxes were filed properly, since loans from 401(k)s are not taxable. It is just borrowing from the account, and is not reported to the IRS, unless it changes to a taxable event, such as you quit or retire from your job. Then, and only then, would the retirement plan administrator send you a 1099-R showing your taxable distribution, reported also to the IRS, unless they have a continuing loan repayment provision for those who’ve separated service. If this was a mistake, amend and get your money back!

  94. Michele says

    There is an exception for loans
    If a loan qualifies for this exception, you must treat it as
    a nonperiodic distribution only to the extent that the loan,
    when added to the outstanding balances of all your loans
    from all plans of your employer (and certain related employers, defined later) exceeds the lesser of:
    $50,000, or
    Half the present value (but not less than $10,000) of
    your nonforfeitable accrued benefit under the plan,
    determined without regard to any accumulated deductible employee contributions.
    You must reduce the $50,000 amount if you already
    had an outstanding loan from the plan during the 1-year
    period ending the day before you took out the loan. The
    amount of the reduction is your highest outstanding loan
    balance during that period minus the outstanding balance
    on the date you took out the new loan. If this amount is
    zero or less, ignore it.

  95. Finance Whiz says

    Good point. But it looks everybody is missing a point.

    yes, the double taxation on 401k loan is a myth. You take out the loan, take money out (no tax), and then put it back within <5 years. No "double taxation" there – author and everybody out there gets it.

    The point we are missing is the fact that the INTEREST on the 401k loan (which is paid back to the borrower) is put back into the 401k account. This in turn will become taxable on withdrawal*. Since this interest is paid with after-tax dollars, so there is a little bit of double-taxation (both at payment and at withdrawal.

    *my understanding based on research. No tax advice is offered based on the above.

    • Harry says

      I explained in previous comments #58 and #73. Double-taxed suggests you are worse off or penalized for taking a loan from the 401k account. In fact you always pay two taxes whether you borrow from your 401k account or not. Whether the two taxes are levied on “the same money” doesn’t make any difference when the amounts you pay are the same.

  96. Ernest Nova says

    Geez. This is still going on? 🙂

    Part of the issue is people inherently assume that calling it double-taxed must mean it is a bad overall outcome. As the author has patiently explained, whether you took a loan and paid it back or left the money in the 401K and took a loan from somewhere else, your net financial outcome at the end is the SAME from a tax perspective.

    This is because if you do not take a loan from your 401K the money left in your 401K is also growing every year (lets call it interest) and that accumulated interest will ALSO be taxed when you withdraw the money.

    Contrast this to say a 10K loan you took out from a bank. Now you are making interest payments with after tax amounts. Taxed once. Fine. But wait, the 10K money you did not take out from the 401K is still there in the 401K and also still earning interest. That interest the 10K is making in the 401K WILL be taxed in the end. So the same 10K is being taxed in two places even in the case of the bank loan. See how that works?

    So call it double-taxation, or two taxes, or whatever causes you to sleep at night – but if you are taking a loan you are not being penalized if you take a loan from a 401K.

    If anything, for reasons outlined earlier, you may get a better interest rate than the bank, so you would be better off.

  97. Ernest Nova says

    I would like to know if there is a way to #hack the 401K loan process for a better outcome.

    If my employer has a 4% match, so I do contribute to the 401K, but the 401K investment choices are limited and are returning around 5% per year, and I can take a loan of $50K out at 4.25% currently, what rate of return would I need on an alternate vehicle where I could reinvest that $50K for a better overall outcome.

    Has someone created a spreadsheet to model this based on marginal tax rates etc.

  98. Frank T says

    Anyone believing 401(k) loans are double taxed is forgetting that they get to use the NON-TAXED proceeds to, for example, buy a car. This is immensely important because when you pay back the loan, you are simply paying the income taxes on the amount you used to buy the car. Therefore, we do not have double taxation.
    Assume you want to buy an $8,000 car and are in a 20% tax bracket.
    Assume you have a 401(k) with exactly $8,000 in it and you can borrow all of it.
    If you pay cash for the car, you would have earned $10,000 to do so since you would only receive $8,000 after taxes.
    If you take a 401(k) loan for $8,000 you must only earn $8,000 to do so since it is not taxed. Since you must pay income taxes on money used to buy cars, you use taxed dollars to pay it back, meaning you have to earn (you guessed it) $10,000 to pay back your $8,000 loan, which is the same thing as the cash price. The only difference is that you get your car sooner.
    In the end, both options (A, paying cash or B, taking the loan) require you pay exactly $2,000 in taxes and leave you with $8,000 in your 401(k), and a car. If buying a car with cash is not double taxation, then neither is using a 401(k) loan.

  99. Viennes says

    No one seems to get this. It’s very simple,

    Step 1.
    You take a 50K loan from 401k, you are taxed at 25%, you end up netting 37.5k CASH.

    You immediately use that SAME 35.5K(already taxed) CASH and repayed that SAME LOAN and you would still owe 15K CASH. That 15k (already taxed) would also come from net earnings. No problem so far right? Right.

    You just withdrew 50k , of which the govt earned 15k, and you earned 35k.
    You paid YOURSELF back that 50k in the form of 401k repayment, and you now decide that you want to take that SAME 50k loan again. See step1 for the breakdown of earnings.

    Here’s the kicker you borrowed 50k twice from YOUR 401k totaling 100k. Note that it’s the SAME 50k, however, it’s been taxed twice so the govt has earned 30k off or your 50k.

    You say, “who borrows” from their 401k twice in a lifetime. Well, that’s essentially what you’re doing when you borrow once, and take a final distribution at retirement. 50k-15k(loan)-15k(retirement dispersal)=20k(in your pocket) and 30k to uncle sam.

    • Peter Krieger says

      Some important details – many contributory retirement plans permit loans totaling half of the balance. So, if a 401K plan has a $50K balance, the maximum loan is $25K.
      The loan proceeds are not taxed. So a $25K loan is free-and-clear of any taxes, provided you remain with your employer for the duration of the loan. Any unpaid loan is considered a distribution subject to taxes.
      The money to pay it back will be after-tax dollars, and those after tax dollars will be taxed again when withdrawn in retirement.
      Another fold – some 401K plans permit ROTH contributions, so withdrawals in retirement are tax-free (but the contribution dollars are taxed).

      If a person takes out a loan, that loan is paid back in after-tax dollars.

      The most important point is that a 401K is a SAVINGS plan, and not an account that can be ‘raided’ in the event someone wants to drive away in a brand-new sports car; the consequences of non-payment are quite costly.

      Any debt will impede future cash flow; savings increases future cash flow. Any 401K loans are going to reduce your cash flow by the principal and interest payments; if the proceeds are used to reduce high-interest borrowing, then you are arbitraging cash flows (this can work to your advantage). A 401K plan loan is a tool to be used wisely; particularly if your employer is prone to bouts of corporate anorexia (layoffs).

    • Frank says

      Viennes, your scenario assumes you are taxed when you take a 401(k) loan. That is not the case. You are taxed when you take a distribution, which is very different than a loan. Thus, you are not taxed twice, just the once when you take a distribution (hopefully when you retire).

      The fact that loan repayments are taxed is making up for the fact that you used non-taxed money to purchase goods/services with the loan proceeds. So there is still no double taxation.

  100. Viennes says

    Peter: The statement “if a 401K plan has a $50K balance, the maximum loan is $25K. The loan proceeds are not taxed.” is inaccurate. It is considered as income and must be filed as such. I know because I just went this exact scenario in 2012 in taking out 25k of a 50k balance in my 401k plan.

    I HAD to declare that 25k as income on my 1040.

    • Harry says

      Who HAD you declare that $25k as income on your 1040? Sounds like you overpaid your 2012 taxes. Amend your return and get that money back. You are welcome.

    • Peter Krieger says

      It sounds like we are discussing two different concepts here (please correct me if I am wrong).
      Your situation is that you WITHDREW money from your 401K plan, and, according to my understanding of tax law, that is considered a taxable event.
      The circumstances that I am describing are a formal loan, administered by the plan’s record keeper, taken from my assets in the plan, and paid back via paycheck deduction.
      The payment amount consists of both principal and interest; due to the nature of tax law, interest MUST be charged for it to be considered a loan; even if you pay yourself back the interest.
      These are two different concepts; I have taken some loans from the 401K plan over the years, and paid them back in full; at no point did I ever have to declare the loans as income when I filed taxes. I even asked my CPA.
      I do believe that if you take out a mortgage loan to make an IRA contribution or any kind of investment there are tax consequences. Perhaps that extends to using a mortgage loan proceeds to pay back a 401K plan loan. I am not certain on that one.
      But, if the withdrawal is structured as a loan, it is not a taxable event. Loan provisions exist because fewer people would participate in defined-contribution plans if they could not access their money.

    • Harry says

      Maybe you left your employer and you didn’t pay back. Just a plain loan isn’t a withdrawal; no 10% penalty either.

    • Harry says

      Not correct. If you are still with the same employer, paying it back through payroll deduction, the loan is not a withdrawal, not taxed, no 10% penalty. Even if you terminate, some employers’ plan allows you to continue the payments on your own. In that case it’s still not a withdrawal, not taxed, no 10% penalty.

  101. Viennes says

    I see your point now. The mis-understanding may have been in that the tax advisers interpreted the withdrawal as a ‘hard-ship withdrawal’ whereas it was actually only a loan taken out against my 401k balance. I’ll check with my tax advisers again.

  102. Viennes says


    Spoke with my tax adviser. Got my answer. Here’s the deal….

    401k loans CAN be taxed IF they do not satisfy all of the below conditions.
    This he said is clearly documented on the 1099-R forms.

    1. The loan is evidenced by an enforceable
    2. The agreement specifies that the loan must be
    repaid within 5 years, except for a principal residence,
    3. The loan must be repaid in substantially level
    installments (at least quarterly), and
    4. The loan amount does not exceed the limits in
    section 72(p)(2)(A) (maximum limit is equal to the lesser
    of 50% of the vested account balance or $50,000).
    Certain exceptions, cure periods, and suspension of
    the repayment schedule may apply.

    The loan agreement must specify the amount of the
    loan, the term of the loan, and the repayment schedule.
    The agreement may include more than one document.
    If a loan fails to satisfy 1, 2, or 3, the balance of the loan
    is a deemed distribution. The distribution may occur at the
    time the loan is made or later if the loan is not repaid in
    accordance with the repayment schedule.

    If a loan fails to satisfy 4 at the time the loan is made,
    the amount that exceeds the amount permitted to be
    loaned is a deemed distribution.

    Note that if a loan is treated as a deemed
    distribution, it is REPORTABLE on Form 1099-R using the
    normal taxation rules.

    That’s the bottom line. Hence, double taxation.

    • Harry says

      You are still not getting the straight answer. Yes it can be taxed if those conditions are not met but the 401k provider will make sure your loan meets the requirements: it has a written agreement, the term is within 5 years except for principal residence, the amount is 50% or less of your balance, etc. So who botched your loan and turned it into a withdrawal and made you pay tax and penalty? Are you still working for the same employer? Are you still paying back the loan through payroll deduction? If yes, ask your 401k provider why they issued a 1099-R for your loan.

      A normal 401k loan is not taxed. No double taxation.

  103. karthik says

    Good article, but what about the taxes that you pay on the interest payments when you contribute and withdraw?

    • Harry says

      You would pay them anyway even if you don’t borrow. You pay tax when you earn your salary. You pay tax when you withdraw from your 401k. Same two taxes, whether you borrow or not.

  104. Rob says


    Isn’t it amazing how much confusion can be caused by irresponsible statements by so-called financial experts? I have had this loan debate with numerous colleagues who were convinced otherwise until I could ” ‘splain things ” to them. Just heard another talking head on CNBC last week crowing the same double tax garbage.

    My simplest example is to pretend you take the loan and immediately pay it back because you found you didn’t really need the money. Were you then double taxed? It usually shuts them up. My second point is to ask; okay, so let’s say you get to repay it with pre-tax deductions again – isn’t that a double tax benefit? Wouldn’t that be sweet?

    Loved the Bellboy story too. My father sprung that one on me when I was a teen over 40 years ago. He made me figure it out!

    Good stuff here! Care to tackle the Roth vs Regular IRA next? LOL.

  105. $iddhartha says

    Sorry, but I can’t resist attempting to clarify because I believe that 401k loans can be very useful for certain people.


    1) You borrow money from JoeBlowBank. You pay interest with after-tax money. JoeBlowBank is taxed on the interest earned.

    2) You borrow money from your 401k. You pay interest to your 401k with after-tax money. You are taxed on the interest earned (even though you paid the interest to yourself).

    3) You don’t borrow from your 401k. That money remains in the  401k, and its earnings are taxed (assuming the investments go up).


    #1 Two different entities are paying the two taxes.

    #2 The same entity (you) is paying the the two taxes… Which is why many term this “double tax.”

    #3 You would have paid taxes on any earnings from money not borrowed from 401k anyway. Which is why some say the “double tax” is irrelevant.

    • $iddhartha says

      Personally, I am okay with the term “double taxation” because I strongly believe that the IRS should not be allowed to tax interest paid to oneself. However, I also agree that this double taxation is almost completely negligible in a decision to take a 401k loan.

      Keep in mind, this 401k loan double taxation is ONLY referring to the INTEREST portion paid to yourself and not the principal.

  106. Don says

    ******** This article is so ridiculous it’s laughable. ************ Many “experts” agree with Orman’s statement but then again experts are not always right. Neither is this author here.

    Yea, technically it’s taxed twice but it will always be taxed once anyway. 401k withdrawal the money is taxable when it comes out whether you paid back a loan or not.

    The negatives on a 401k loan are many but with regard to the tax issue it’s simple .

    You’re taking pretax dollars paying it off with post tax dollars so you lost the pretax dollar contribution benefit. Period- end of story. This is what they are referring to as the “2nd tax”.

    Don’t listen to one “expert” 1/2 of them are idiots.

    • $iddhartha says

      “You’re taking pretax dollars paying it off with post tax dollars so you lost the pretax dollar contribution benefit. Period- end of story. This is what they are referring to as the “2nd tax”.”

      This is precisely the misconception being referred to actually.

      The fact that you pay back the principal portion of the loan with after-tax money is irrelevant because you still received the tax deduction on your initial contributions. However, you also pay the interest portion of the loan with after-tax money. This interest portion is additional money above and beyond your original contributions and the full amount will be taxed when it is taken out of the account. Therefore, the interest portion is the only part that is “double-taxed.” Since the interest on such a loan is relatively insignificant, many–including myself–say the double taxation is largely a non-factor.

      TFB is simply arguing that if you don’t take a loan then your balance would be taxed on the growth of the money that remains in the account anyway… so either way you look at it you are still paying a tax.

  107. Gaurav Kumar says

    I think there is a double taxation and let me explain how, albeit in special circumstance like mine.

    You took a loan of $100 from 401K. Lets say you had $200 in your account. Now since those 100 you took would have costed you 130 dollars had you took it from some other source, assuming 30% tax bracket.

    Now lets say you are going to now pay the money back to 401K. There can be two scenarios:

    1. You are still employed with the same company and your 401K account is active. In this case, you can continue to pay the loan with pre-tax dollars. So basically, you will again only use your $105 dollars (adding some interest) to your own 401K account. This is a good case, you are not overpaying. They will levy the ongoing rate of tax when you withdraw this $100 on your retirement.

    2. You have changed jobs, and your 401K account is not active. In this case, the only option to pay the loan back is using your taxed dollars. So you will be paying them the same $105, but note, this would be coming from your taxed money, which means you need to earn around $142 dollars to really put $105 dollars in the 401K account. Now you have paid already tax on it. Now move forward to the time you want to withdraw money on your retirement. Now again, IRS will levy the ongoing tax rate on this money, which means they will put another 30% tax on $105 and any growth you would have made. So in nut shell, you will get around $70 from $142.00 dollars you actually earned.

    This is how it is double taxed. Hope it explains.

  108. Barbara Passarge says

    My husband took out a $3,000 loan from his 401K plan. His deductions from his paycheck for the principle plus interest is reinvested into his 401K, is this correct?

    The problem I have is that he was fired so his company deducted the remaining balance of $2500 and sent the remaining balance of his 401K plan to him. If the original funds source was the sell off of his stock then where does the $2500 sold stock to pay the loan off, who gets to keep the cash from those stocks that were sold?

    • Harry Sit says

      The remaining loan balance is part of the 401k balance. Suppose he had $10,000 at the time he got the loan, $3,000 worth of investments was sold off to give him the loan. The 401k balance was still $10,000: $7,000 in investments, $3,000 on loan to him. Fast forward to today, suppose the 401k balance is now $10,500: $8,000 in investments, $2,500 in loan balance not yet paid. When the 401k account liquidates, he gets only the $8,000 in investments. If he paid the 2,500 off before it liquidated he would get the whole $10,500.

      If you don’t want to pay tax on the $2,500 loan balance and on the distribution, add $2,500 to the distribution and roll it over to an IRA.

  109. CP says

    This is a bad analogy – the difference is the money you borrow from a “bank” is not your money, the money in your 401K is indeed your money! come on. bottom line you do pay taxes twice on the money you borrow. you are better off taking an earlier withdraw than a loan. why doesn’t the gov. allow 401k loans to be paid back with pre-tax money just as you put in to begin with? NM I know the answer to that question.

  110. Dan says

    I’ve recently decided to go back to school, and I’m looking to borrow against my 401k to make my tuition payment. Upon completion of the semester, my employer will reimburse me, in full, for my tuition and related expenses. Because I will be reimbursed in full (up to $5250 yearly) in a lump sum untaxed payment, are there any foreseeable negatives to taking this loan? Also, should I set a greater loan length than is needed, say 60 months, to minimize the amount withdrawn from my paycheck to repay the loan, and then satisfy it once I receive the tuition reimbursement?

    • Harry Sit says

      Ask your plan administrator whether you can pay off the loan early with a lump sum deduction from your paycheck or a separate check you write. Also ask whether you can continue the loan payments even if your employment terminates. One possible downside is if there is a change in employment, you won’t get the reimbursement and you have to pay off the loan right away.

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