Double Taxation and the Real Reasons 401(k) Loans Are Bad

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:

  1. 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.
  2. 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?
  3. 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.

Summary
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.

Comments

  1. Exactly…. and about the only popular press financial advice usually worth repeating is buy low and sell high (and that was probably from Benjamin Graham ….).

    If you think about it, in this investing environment with decreasing stocks and minimal money mkt return, taking money out then repaying it at 6% might be the only way to increase your retirement bucket (only said partially tongue in cheek….)!

  2. True, you should examine your reasons for taking out a loan. That’s key.

    The old rule about debt still applies. Debt is bad, even if you’re in debt to yourself.

    Plus, even though you pay yourself 6%, isn’t it better to have someone ELSE pay you the interest? Like the growth from the $10,000 if you had left it invested?

    Moreover, another disadvantage would be if the market had a really good year. Sure, you paid yourself 6%, but if you had left the money in the 401k, it could have made 10% or 15%.

  3. I see this over and over as well, and the best explanation I can think of is to illustrate why it is a bad idea to take the loan.

    I think the other part of it is that when most people are taking a loan, they are probably also stopping their regular contributions. So if they were making a $200/month pre-tax contributions, then take a loan that has a $200/month repayment amount and they stop making regular contributions, then they are missing out on the tax benefits. They still are only being double taxed on the interest, but now they aren’t reducing their income by $200/month to save on taxes either.

    But as you mentioned, if done properly, they can be a reasonable alternative for getting money. The real problem is that most people who take the loans don’t do it properly, or end up leaving their job and getting screwed, etc. which makes it a bad idea for most people.

  4. I much better idea is to not put your money in your 401K in the first place. Don’t fall for the ‘free money’ bait on the end of the stick. The government created 401k plan is not as good of an investment option as marketed to be. A better option is to pay the tax on your money today, while the tax is low, and use the money to build a savings account. That way you can borrow against your own savings when you need a loan.

  5. sth_txs says:

    Of course, this post begs the question why for a “free country” most Americans allow so much control of their personal wealth by multimillionaire elected officials that have no clue how the average American lives.

  6. Melissa says:

    Thanks for this article. Not that I would ever take money out of my 401(k), but I didn’t realize that only the interest portion is taxed twice. It’s always nice to learn something new.

  7. Wow Curt, you have it all figured out. Pay tax on your income, save some of it. Earn just enough to keep up with inflation if you’re lucky, and then get taxed on the interest each year. That is what all the wealthy people do.

    I agree that you should have money set aside in savings so that you can access it when you need it versus tapping into a retirement account, but to suggest that the 401k is not as good as a savings account is just foolish.

  8. do you have a site where i can go to to find the tax brackets in my state?

  9. heather says:

    Great point. That’s been bothering me for years.

    Another knock against pulling out money from your 401k (I think) is that this money is taxed as ordinary income, rather than at capital gains rates. So you are kind of “blowing” the tax-free compounding benefit of a 401k if you pull out that money to e.g. buy a house, compared to having just put that money in a non-qualified account.

  10. In the scenario you created you are correct, that you are paying back the money with pre-tax dollars, but is it realistic? It wouldn’t make sense to just borrow money, put it away for a year, and then pay it back (unless your going to try and invest it that is).

    The double taxation (I think) they are getting at is that you are going to take out a loan and then you are going to do something with the money besides investing it (buy something, give a gift, etc…). But the key is you will no longer possess the money you originally took out.

    Now when you go to pay back the loan, you will be paying it back with after-tax dollars, and then get hit up again with taxes when you withdraw.

    It seems like you guys can both be correct, depending on the scenario.

  11. Sorry, but the cost of the loan is not 1.5% in your example, but rather the risk-free rate of perhaps 5% — due to this thing called opportunity cost. While you have $10k loaned to you from your 401k, you’re not earning interest from other people on that $10k.

    Situation (a): take out loan, end of 1 year you have $10,600 in 401k and paid $150 in taxes. (assuming 20% tax rate)

    Situation (b): don’t take out loan, end of 1 year you have $10,500 in 401k plus $600 in taxable and $150 paid in taxes. (assuming 20% tax rate)

    Note that you’re $500 richer in situation b.

  12. "Mo" Money says:

    I agree with Suze. If you pay back the loan from your 401k, you will be paying taxes twice on that money.

  13. Zoolander says:

    Gecko1, he wasn’t saying that he would take out a loan from a 401k and just sit on the money only to repay it. Yes, you are going to use the money from the 401k, but you are going to use it to make a purchase or pay off another debt, which you would be using after tax dollars on if you had the money. You are using untaxed money (from the loan) to pay down debt, and refunding it with taxed money. He is correct, you are in no way getting double taxed on everything, only the interest.

    And finally somebody who sees this double taxation as ridiculous. Every time i read about this double taxation on 401k loans I feel like i’m taking crazy pills.

    Derek “only one look” Zoolander

  14. If you spend some more time thinking about it I suppose you could logically conclude that if you are taking out the 10K, and then buying something — you are buying it with pretax dollars, then when you go to pay back the loan, you are getting taxed on the payback (in this case you could argue that they essentially cancel each other out — assuming you were in the same tax bracket throughout the process).

    So in that case, you are technically getting taxed twice, but in reality, prolly only once.

    Fun little exercise.

  15. @Gecko: What you said might make sense if you’re just spending the money on depreciating assets. But doing that is dumb, just like buying stuff you can’t afford on a credit card is dumb. However, there are good reasons to take out a loan — investments, where your expected rate of return is greater than the loan interest rate. I was considering doing a 401K loan awhile ago to raise cash to partake in an investment opportunity. The opportunity didn’t pan out.

    But loans aren’t always evil. Sometimes loans are good, in order to finance investment opportunities.

  16. I agree completely with Jonathan. I have never been able to understand why this idea of “401K double taxation” is promoted so heavily by ‘people in the know’.

    This is a great post that clarifies the issue.

    For all the doubters out there: The overall point is that you can’t (mostly) spend money unless you have paid taxes on it.

    So you basically have three choices which are basically equivalent (ignoring interest) 1) spend your after-tax salary, 2) take a loan from the your 401K and pay back with your after tax salary, or 3) take a loan from a bank and pay back with your after tax salary – it doesn’t really matter.

    Gecko1: “and then get hit up again with taxes when you withdraw.” – no you are just paying taxes on money that has not had taxes paid on it.

    Using the same popular logic another example of ‘double taxation’ is when I use after tax money to pay my plumber, who then has to pay tax on that same money. Double taxation some would say ! NO – just everyone paying tax on income they receive.

  17. Justjoeguy says:

    Maybe the $600 interest is deductible if the money was used for an investment or business purpose? The deduction offsets the expense. Also if interest rates are high you get a better return on your money by paying yourself a high interest rate. The prime rate is always higher than the money market rate I think?
    Also Orman didn’t say if social security and medicare and other taxes are taken out but they might be so then the money that goes into a 401K might not be completely pretax? But is that true?

  18. If you take out 10K from the 401K and use it to buy a car, you’ve paid for the car with pretax dollars. When you then go to pay the 10K back a year later its true your paying with taxed dollars, but your original use of the money was with pretax dollars, so taxwise its all equal in the end (You’ve paid 10K of taxed dollars at the end of the year for the car). Maybe that will help you guys understand why its not taxed twice?

  19. Actually If you have $10,000 in a 401K and you also had $10,000 in credit card debt at 20% APY, taking a loan against your 401K isn’t such a bad idea.

    The thing that’s really appealing about retirement accounts is that even in the event of bankruptcy, creditors cannot touch your money.

  20. Curt:
    “I much better idea is to not put your money in your 401K in the first place. Don’t fall for the ‘free money’ bait on the end of the stick. The government created 401k plan is not as good of an investment option as marketed to be. A better option is to pay the tax on your money today, while the tax is low, and use the money to build a savings account.”

    In your model you pay tax on every realized gain e.g. dividends, churn etc, lowering your effective capital gains rate. With compounding interest that has a HUGE effect. Unless you buy and hold non-dividend investments for the entire time from purchase until you withdraw cash during your retirement OR if the tax system becomes ALOT harsher, you are MUCH better off with a 401k or something of similar ilk.

  21. Yes the double taxation that is being referred to is that you are paying back your 401k with aftertax dollars. Usually a loan is used to pay for something else. I highly doubt someone is just going to sit on the money.

  22. Gecko1 is correct. In the scenario you used there is no double taxation. But that scenario would only apply if you are not spending the funds you took out with the loan.

    Once those funds are spent, you will incur double taxation by repaying the loan with after-tax dollars and then being taxed on those dollars when you finally withdraw them from your 401k.

    So if you took out a $10000 loan and only spent $6000 you will have to repay the $6000 you spent with after-tax dollars but could return the unspent $4000 before-tax dollars.

  23. who cares about double taxation when ur sinking in debt with $70K credit card debt and paying interest rates of 15% to the CC folks??

    I advised a friend to take out as much as they can from 401K and pay the cards off. They did that and they are so glad to be back in control of their finances. They will be debt free in 4 years VS lifetime of CC debt that just wont go away and not having a dime to save at the end of the month. I think they did a wise desicion. Screw the double taxation…..lets not be penny wise, pound foolish

  24. To those who are saying “it’s double taxation because you’re buying something with the money, not putting it under the mattress”… take a moment and think how little sense that makes.

    Let’s say I borrow $30k from my 401(k) to buy a car. Is it true that I’m repaying the 401(k) loan with after-tax dollars? I suppose, but HELLO! I didn’t pay any tax on the money I used to buy the frickin’ car!

    Let me run the numbers for those of you who still don’t get it:
    Let’s say I start with 100k in a savings account and 100k in my 401(k), my tax rate is 25%, and we ignore interest payments (we’re talking about taxation here, not interest).

    If I pay for the 30k car out of my savings account, I have:
    $70k in my savings account, and $100k in my 401(k)

    On the other hand, let’s say I pay for my car with a 401(k) loan that needs to be repaid after one year:
    I now have $100k in my savings account and $70k in my 401(k). But after 1 year, I have to pay my 401(k) back from already-taxed money in my savings account, so I am MIRACULOUSLY left with $70k in my savings account and 100k in my 401(k).

    As if by magic, my result is the same either way. You can call it magic, but anyone who has studied arithmetic will call it “DUH!”

  25. To Gecko1 and Joe,

    You are getting confused with Jonathan’s example. It doesn’t matter if you stuff the borrowed money under a mattress or invest it or spend it on gifts. It’s the same net result.

  26. You are correct, sir! And since I have a self-401k, it is not tied to employment. (Risk 1 eliminated.) I am financially solvent, even as I need cash, and the 401k is a safer choice than credit cards. (Risk 2 put into context.) And I don’t get a match as a self-401k. (Risk 3 eliminated.)

    Really with a self-401k it’s not a dangerous or expensive option.

  27. El Cheapo says:

    Don’t forget that another reason to give pause when borrowing against your 401K is that you’ll lose the compound interest, earnings, and investment gains on the amount of your loan spread out over the duration of paying it back.

    This may be the bigger hit than the whole ‘double taxation’ argument. Especially since a lot of 401K funds let you borrow 50% of their value for qualified loans….

  28. Jonathan, you logic is flawed here. One takes out a loan implies that there are payments to be made from the loan, for hospital bills etc. You cannot just keep it under your mattress. Now one has to earn income to pay back the loan. In this process you are going to get taxed – this is once. After you put the money back in the 401k you have to pay tax when you finally withdraw it – this is second taxation.

    (you may argue that the “second” taxation would happen even if one does not take out a loan, therefore should not count. But the truth is the source of this money now is after tax income and not pretax income. therefore, there is some loss of investible capital, which is attributed as a second tax).

    Normally, it would be better to take out a loan from a bank. That way you only pay tax once – when you earn the money to pay back the loan. during this time your money in 401k will continue to grow- hopefully.

    I believe Suze implies this. You are just plain wrong here.

  29. Bob, thank you for speaking some sense to these poor souls. Unfortunately, the example in the blog post is somewhat lacking because it’s unrealistic that somebody would borrow 401k money and stuff it under a mattress.

    What people fail to realize is that, by taking the 401k loan, you receive the money without paying any tax on it and you’re free to spend that money however you wish (buy a car, go on vacation, etc). That was money you spent and never paid tax on. Therefore, when you repay the 401k loan with taxed money, you’re simple paying tax that you really already owe. There is no double taxation except on the interest itself. In fact, I would argue that the “delayed taxation” scheme going on here is beneficial to the person taking the loan because between the time the money is borrowed to when the tax is paid, there is opportunity to earn a profit on that money that will eventually go to taxes.

  30. Heath, “delayed taxation” comes at a price. Compute the loss of the growth of the amount of the 401k you took out as loan. Consider the case in which you had accumulated the growth by not taking out the loan. Now calculate the value of this amount after compounding for decades. Even after paying taxes on withdrawal during retirement, you end up in a loss due to the loan.

  31. wsbrinser says:

    person A and person B both have a 10,000 dollar 401k. (ignoring interest lost or gained for one to five years to pay back the 401k loan.)

    person A borrows from the bank. 10,000 loan and pays back 10,000 after tax dollars. In 40 years he pays taxes on the 10,000 to cash out his 401k

    person B borrows from his 401k. 10,000 pretax loan and pays back 10,000 in after tax dollars plus minimal taxes(1.5%) on the interest to himself. In 40 years he pays taxes on the 10,000 to cash out his 401k

    They both have paid taxes on 20,000 dollars! Person B paid 1.5% more for one year which is lower than almost any bank loan. And those arguing the lost opportunity should also consider a bad year. Look at a the lows over the last 30 years and a few are below prime + 1% and many are over so it is a lost gamble of a better opportunity.

    I think what people are missing is that if you borrow from a bank you are only ending up with 10,000 and of course only paying taxes once. It is when you also have the additional 10,000 in your 401k and cash that out that you are paying taxes on this second 10,000 increasing your total to 20,000.

  32. KD, I agree with you. I was not making an argument for or against taking a 401k loan. I was only trying to address the false concept of double taxation with regards to a 401k loan. In essence, instead of double taxation on the loan principle there is actually some delayed taxation going on which certainly is better than double taxation.

  33. Jonathan and others who say it’s not double taxation:

    your logic is flawed as someone already pointed out. Consider this:

    - You have $100 in bank, and $100 in 401K.
    - Now assume 6% return in both, and 0% interest on 401K.
    - Assume you need to spend $100 out of this total of $200 net asset.

    scenario #1: you spent it from bank.
    scenario #2: you take loan from 401K and spent it, and fill in 401K from your income.

    In which scenario will you be better of in 1 year?

    The result is: scenario #1.

    How?
    (note: in preview, i see that formatting gets messed up, so pls bear with me while you read the table below)
    scenario #1:
    bank 401k
    beginning: $100 $100
    spent : -100 0
    increase : 0 6%
    ===============
    result 0 $106 at the end of the year
    TOTAL: $106

    scenario #2:
    bank 401k
    beginning: $100 $100
    spent : 0 $100
    increase : 6% 0
    401K fill : -$133 (need $133 to fill 401K from after tax money)
    ===============
    result $106 -33 at the end of the year
    TOTAL: $73

    So you do get doubletaxed, don’t you?

  34. I agree 100% that taking out a loan against your 401(k) is not a good idea. There are a lot of reasons it’s a bad idea, but double-taxation is not one of them.

  35. i think a loan from a solo 401k is a great way to access money to put towards other investments/businesses. you are paying yourself interest that you would be paying the bank and earning more from your new investments than the interest you are paying on the loan.

  36. PCK_Brooklyn says:

    Let’s run a thought experiment.

    It’s March, and you are gathering your papers for the annual visit to the accountant.

    Your CPA asks you “Did you make any IRA contributions this year? You can deduct the full amount!”

    You know that although you should have you did not. A lightbulb then goes off above your head. Borrow from the 401K and use the proceeds as an IRA contribution!

    You take out $5000 loan, with an agreement to pay it back over the next year (this will really shrink your paycheck, but that is another matter).

    You drop the loan check off @ the bank, then open an IRA w/ your favorite mutual fund once it clears.

    You make sure that the entire amount is categorized as a prior year contribution and then you let your CPA know. For the sake of argument assume the IRA contribution helps a little bit w/ the IRS.

    Further assume the interest rate is 7%, you will pay about $350.00 in interest (probably less as it is likely to be an amortizing loan). If you can get that much on the assets held in the IRA, you are about even (not impossible w/ a conservative balanced fund).

    The only downside is that once you retire you will be paying taxes on the interest > and this is money on which you will have already paid taxes.

    That aspect of the argument is valid, but I think that if you can make a contribution to a deductible IRA, it is worth looking into; if you cannot make a deductible IRA contribution, then consider a contribution to a ROTH IRA the money still compounds tax free.

    What do you think?

  37. I submitted my 2nd post @20 minutes after the first, but it was in moderation for about @6-8 hours before it got posted…weird.

    Again, based on a given scenario, you can argue things either way, looks like there is enough gray in the issue unless all variables are set (tax bracket when you paid the $$ in, when you took it out, how long you took to pay it back, etc… you could even add the inflation rate if you want to cover all bases). Do I think you could be out up to 25%? (if your in that tax bracket), extremely unlikely.

    More than just “double tax” paid on the interest? Certainly possible, given the right scenario.

    Jonathan, thanks for the razor link! I haven’t had to buy any in about a year :-)

  38. auntie_green says:

    actually, PCK_Brooklyn, you say the “only” downside. There is actually another. What if you get laid off? Or decide to leave yoru job because you found another? Then you gotta repay the loan right away. If you spent the $$ on a car, how are you going to repay it? So are you going to stay in your stinking job and not take another opportunity because you don’t have the cash to pay back your 401K loan?

  39. PCK_Brooklyn says:

    auntie_green:

    Excellent point; these are all important considerations.

    My thought experiment was focused only on the IRA contribution.

    If you buy a car w/ the proceeds of the loan, then selling the car would not likely produce sufficient revenue to pay off the loan.

    Under ideal circumstances, one would have access to $5000 for an emergency repayment (which might consist of a short term loan from another, non-401K source).

    Again, it is not the ideal way to do it but it **MAY** serve in a pinch.

    PCK_Brooklyn

  40. @maulik, your flaw is with the fact that you are not accounting for the original source of the $100 in the bank. The $100 in the 401k was never taxed whereas the $100 in the bank has already been taxed. Once you account for the fact that you would have had to earn $133 to get that $100 in the bank (after taxes), this explains the $33 difference in your bottom line.

    There is no gray area here. Any example that accounts for the complete money trail (employer’s pockets to your pockets or your 401k including associated taxes) will show that there is no double taxation of the loan principle.

  41. PCK_Brooklyn, I like your experiment.

    How about this one…

    a) Person makes lots of additional income from overtime but realizes that taxes eat up most of it.

    b) Person decides to borrow maximum allowed from 401k & uses it as funds to pay for monthly expenditures.

    c) Person then maxes out monthly contribution to 401k by taking it out of his monthly paycheck.

    d) Person has money left over from paycheck and uses it to pay off loan balance and interest.

    Let’s assume that 401k plan ALLOWS new contributions even with the loan outstanding. There is also NO 401k matching contributions from the employer.

    I like this scenario because it lowers taxable income each paycheck all the while maxing out your 401k.

    But I’d like to put it to you guys… Do you guys see a problem with this kind of scenario?

    -Angelo

  42. I understand that this can be a confusing point. I can’t rebut every single comment, but I can say that I am still confident that there is no double-taxation of loan principal occurring.

    I’ll try to think of a better example, most likely involving more math (which I tried to avoid initially).

  43. @maulik Your “scenario #1″ neglects to account for replacing the money in the bank after spending it. The end-of-year amounts are the same after correcting for this fact:

    scenario #1:
    bank 401k
    beginning: $100 $100
    spent : -100 0
    increase : 0 6%
    bank fill : -$133 (need $133 to fill bank from after tax money)
    ===============
    result 0 $106 -33 at the end of the year
    TOTAL: $73

  44. whether it makes sense or not to borrow against a 401k only the individual can decide.but since all taxes hurt this is just another bite from our never satisfied goverment.which ps we voted for.

  45. Jonathan…talking about a Jedi mind trick. Not too long ago, I posted about double taxation on my blog. But now that I am reading your article, it completely makes sense. However, even without the double-taxation, I still think taking 401k loan is a bad idea. :-P

  46. wizard of aas says:

    All things being equal, there is no difference or deferral between the bank vs 401k argument.

    Borrow $10k from a bank at 6% interest. You are taxed on the money you make to pay the interest. Earn 6% in your 401k. You are taxed on that at withdrawal too. Pay back the $10k with post-tax dollars. Payments are in equal installments over time. Each dollar you pay the bank stops costing you interest, but does not earn anything more.

    Borrow $10k from the 401k instead. Pay yourself 6% with post-tax dollars. You get taxed on the interest income of 6% at withdrawal, same as above. Pay back the $10k with post-tax dollars. Payments are in equal installments over time, same as above. Each dollar you pay the 401k goes back to work earning 6% from someone else, compounding the return?

    Almost makes it sound like the 401k is a better deal, but remember, the $10k in the 401k was ALWAYS earning 6% in both scenarios. The last sentence in each of the preceeding paragraphs is irrelevant.

    My point is that there is really no difference, but it is all too easy to get confused by a story that sounds like it makes sense. From purely a numbers standpoint, the question is whether the 401k money would yield a better return than the interest rate you would pay for borrowing it, giving due weight to risk, which varies according to circumstance.

  47. Double taxation does occur. When you take out a loan against your 401K, you are repaying the loan with money that has been taxed already (this is the first taxation).. when you withdraw your money at retirement age where the money that you used to repay the loan is a part of now… you get taxed.. and possibly even at a higher tax rate depending on your tax bracket at retirement (second taxation )

  48. kim, i’m sorry but you are not correct. there are numerous examples in these comments as well as two examples presented by the blogger (in this post and one he made a day or two later). what you (and many others) fail to account for is that when you take the loan, you are being handed a lump sum of money that has not been taxed. therefore, the “taxed” money you use to pay that loan back is basically a form of delayed taxation. in other words, you already owed that tax because you went and bought a house, boat, car, or whatever with the 401k loan money that had never been taxed. you gotta pay the piper at some point.

    you are only doubly taxed on the interest that you pay back to yourself, not on the principle.

    it’s amazing that mainstream media and “tax professionals” distribute the message that double taxation occurs on a 401k loan principle. it’s simply not true.

  49. Question about college financial aid formulas: How much do financial aid offices look at home equity in deciding how much students and parents should contribute? I’m hearing all sorts of news about colleges dropping/lowering tuition for families with household incomes less than $75000 or so, but my brother-in-law’s niece had her dad’s home equity factored into the equation. Which makes me wonder if paying off our mortgage early is a great idea afterall. Any comments?

  50. Jonathan, where did you get the 60 day pay back rule from? I can’t find that in the IRS regs.

  51. It really makes sense to use your 401k for any necessary purchase you will need to finance as long as you continue your contributions if there is an employer match. To determine if you should, just add the 401k loan rate to the finance rate for the purchase/debt and subtract the expected rate of return from the market(say 8%). So if you get a 401k loan for 4% and use it instead of a car loan 7%. Its like getting an 11% return. 7% you pay someone else 4 % you get yourself. This beats the the market by 3%.
    It becomes more complicated if the loan is tax deductable. For example a home equity line at 7%. Assuming this puts you in the 25% tax bracket the effective rate is (10k * 7% = 700, 700 * .25 = 175 tax return, effective APR .0525) 4 + 5.25 = 9.25 % return which beats the market by 1.25.
    Of course the market could beat the 8% estimate or do much worse.
    The main problem with borrowing from the 401k is that the person may not be fiscally prudent. If you use the loan to pay down Credit card debt its a great idea as long as you don’t run those cards up again.
    Please contact a Financial advisor and tax specialist for individual circumstances

  52. Michael, the problem with your calculation is that the return on the 401k loan is paid by yourself. You are essentially paying yourself interest (4% in your example). Therefore, I don’t think it’s correct to compare this return to return from the market. By doing this, you are comparing money coming from your pocket with money coming from other people’s pockets. Apples and oranges.

    It makes more sense to directly compare the loan you are replacing with expected market return. In your example, you would be better off not taking a 401k loan because the return on your 401k dollars (8%) would beat the loan interest (7%).

    In other words, anyone is free to pay themselves 4% on a random sum of money. But it really has no impact on your true return.

    On a side, anyone who had a large 401k loan out over the last year is probably considering themselves lucky. Hopefully, these same people were able to repay the loan when the market was down.

  53. 401K loans are excellent for buying vehicles. New car loans typically have low interest rates, but the cars are overpriced. Unless you have perfect credit you’re going to pay high interest for a good used car (which the dealer plays with to line his pocket with, too). Get the loan, pay cash, and the low interest goes right back into your account.

  54. The “double taxation” scam is merely a way for those people who think all Americans are stupid to scare tax-shelter owners into not borrowing against 401(k), 403(b) or other tax shelters.

    We borrowed from my wife’s 403(b) plan to build a barn. Three years later we paid it off. We could have borrowed from a bank, paid exorbitant interest rates, and fees and had the barn. Instead we used the 403(b). Today we have the same 403(b) account with the same balance we had prior to taking out the loan, and we have a barn – which we would have had to pay income tax on either way – exactly as it would be if we had instead gotten the loan elsewhere. The double taxation argument is a total farce.

  55. Is not double taxed!

    If you argue that you are paying taxes on the $10K then you also have to argue that you are getting the $10K from the plan tax free (since you never paid taxes on it). $10K tax free zeros out the $10K you are paying taxes on. If you use logic on one side you have to use it on the order side!!

  56. This is a classic “error of omission”. It is true you will be taxed twice….however it is only after having the priviledge of spending money that has never been taxed (try to find another place in this world you can buy something with pretax dollars). This “in effect” cancels out one of the “double tax” costs.

  57. Suze Orman is WRONG, about this an many, many other things. You are not double-taxed on 401k loans, plain and simple.

  58. Hi Jonathan. Thanks very much for your efforts. I just wanted to let you know that I repurposed your example above on my own new blog which offers advice on the Thrift Savings Plan, which is the 401K equivalent for Federal Government Employees. Please let me know if any issues, but I hope that you are just amused to see your work spreading a bit further afield. Thanks, TS.

  59. How long will these financial gurus propagate a myth of double taxation stemming from repaid 401k loan?
    Get some financial education first before writing financial blogs.

  60. If I want to by, say, a $1k refrigerator, I could buy it with cash from my savings (using after tax money) or use a 401k loan (pretax) and pay the loan back with after tax money from savings. There’s little difference between the two. The interest I “paid to myself” is double taxed, but not the principal. The entire amount is not double taxed. 401k loans are not a good idea but the double taxation tale is a tired myth.

Trackbacks

  1. [...] so I view my last post on 401k loans as a failure. I tried to use as little math as possible in explaining why 401k loans are not a bad [...]

  2. Weekend Reading: July 27, 2008 | Moolanomy says:

    [...] Double Taxation and the Real Reasons 401(k) Loans Are Bad at My Money Blog — I wrote about 401k loans before and cited double-taxation as a reason. However, Jonathan gave a compelling argument why this is just an illusion — he still thinks they are bad though. [...]

  3. [...] Double Taxation and the Real Reasons 401(k) Loans Are Bad at My Money Blog [...]

  4. [...] 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 [...]

  5. [...] interest-rate level, these loans can actually be a pretty good deal. (Don’t listen to the double-taxation myth perpetuated by Suze Orman and others.) However, you have the potential penalty of losing the [...]

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