I have noticed an increasing amount of discussion regarding 401(k) loans. While almost all sources denounce this as a bad idea, I take issue with one of the supposed reasons why: double taxation. Suze Orman explains it her way:
Suze says when you put money in a 401(k), it goes in with pre-tax dollars—you add from your wages before the government takes any income tax out. When you take a loan out of your 401(k), you’ll usually have to pay it back in five years—with other money that has been taxed. Then, when you get older and you take money out of your 401(k) plan again, you’ll pay taxes again. “You have just volunteered for double taxation. Why would you want to do that?” Suze says. “Do not ever take a loan from a 401(k) plan.”
So does MSN Money:
Whether you repay the 401(k) loan out of your salary or from a bank account, those payments are all made back into the 401(k) with after-tax dollars. So, let’s say your monthly interest payment is $300 and you’re in the 28% tax bracket. You’ll have to make $416 in gross earnings to make the $300 payment. Then, when you retire and take withdrawals, you pay taxes yet again.
I see this double-taxation argument over and over… These quotes seem to suggest that you’ll lose something like 25% of your principal (or whatever your tax rate is) if you dare take out a 401(k) loan. Why are such trusted sources still spreading this misleading information?
Let’s say you want to borrow $10,000 from your 401(k) plan for a year. Your plan charges an interest rate of Prime + 1% = 6%, which you must pay back to yourself. That $10,000 was a pre-tax contribution, so you never paid income taxes on it. You take it all out, leaving yourself with $10,000 in cash. You haven’t paid any taxes on that $10,000. You leave it under your mattress, and a year later pay back the same $10,000 plus $600 in interest. Still haven’t paid taxes on the $10,000. When you eventually withdraw the money, then finally must you pay taxes. So what was the only thing taxed twice? The part attributable to the $600. Not the $10,000.
Question: Does it matter if it turns out someone took your original 10,000 and then replaced it without you knowing? The answer is no. As long as you pay back the $10,000, that is all that matters.
The only part that is taxed twice is the interest. And since you are paying yourself the interest, this small double-tax is really the only cost of doing this loan. Using the example above and assuming a 25% marginal tax bracket, that means you only got taxed an extra $150 on that $10,000 loan. This is the same as getting a regular loan with a 1.5% interest rate. Dealing purely with the effective interest rate paid and assuming you pay back the loan in a timely manner, a 401(k) loan is actually quite a good deal.
This leaves you with the real reasons not to take a 401(k) loan:
- If you lose your job, you will have to repay the loan within 60 days or it will be considered an unqualified withdrawal. This means you lose any future tax advantages on that amount, and you will be subject to income tax plus a 10% penalty on the amount. This would boost your effective interest rate dramatically.
- 401(k) funds are protected from creditors, even in the event of bankruptcy. If you borrowed money on a credit card and don’t pay it back, your credit score will tank but nobody will take money out of your hands. Just like how home equity loans can be dangerous because you are risking your home, unsecured debt is always better than secured debt. If something is so bad that you need to sacrifice your retirement savings, then bankruptcy may not be that far-fetched. Is this a one-time need, or are you just putting off the inevitable?
- Some 401k loans do not allow new contributions if you have loan outstanding. So you could be losing out on some 401k matching contributions. This loss would also drive up the effective cost of a 401k loan.
401(k) loans can indeed offer you a very low effective interest rate given optimum conditions. However, there are important potential catches, enough that I would still personally take out an unsecured loan first if at all possible. Before taking on any debt, you should carefully examine your reasons for doing so. I think that only those with really bad credit (unable to get loan otherwise) and a short-term need with a quick payback schedule should take out a 401(k) loan.
Update: A lot of people still think double-taxation still occurs. As opposed to editing this post, I went ahead an made up a better example against the theory of double-taxation. Please check it out before making up your mind.