Better Example Against Double-Taxation Of 401(k) Loans

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Okay, 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 idea due to the incorrect concept of “double taxation”. Instead, I probably managed to confuse many of you all further. I have tried to come up with a better example with the math thrown back in, and think I have found one. Please give me another chance! 🙂

The Method

If double-taxation really occurs in 401k loans, that would mean that taking out such a loan somehow negates the inherent tax-advantages of the 401(k) plan. Certainly, taking a loan and paying it back would be worse than just leaving the 401(k) completely alone, right? I am going to walk slowly through three scenarios that will show that this is simply not true. The three hypothetical scenarios:

  1. Elton contributes $10,000 to a 401(k) and does nothing. He does not take any loans of any type. He waits a year and pays for his $10,000 wedding in cash.
  2. Elton contributes $10,000 to a 401(k). He then takes out a 401(k) loan of $10,000 to pay for his wedding, and then repays the $10,000 a year later using after-tax money earned from his job.
  3. Elton contributes $10,000 to a 401(k). He then takes out a credit card loan of $10,000 to pay for his wedding, and then repays the $10,000 a year later using after-tax money earned from his job.

Very Simple Assumptions

Annual gross salary is $20,000. Income tax is 25% of gross income. There is no interest charged on any loans, as I’m just trying to isolate the issue of double-taxation. There is no growth in the funds, either. He doesn’t need to eat or sleep, so no other expenses. 😉 (And yes, 401(k) loans are usually capped at 50% of total balances.)

The Results

Scenario #1: No Loans

  1. In Year 1, Elton makes a total of $20k gross. He contributes $10k pre-tax to his 401k, and pays taxes on the remaining $10k.
  2. In Year 2, he again makes $20k gross and does not make any additional 401k contributions.
  3. He spends $10k on his wedding. The 401k stays at $10,000 the whole time.

Scenario #2: 401k Loan

  1. In Year 1, Elton makes a total of $20k gross. He contributes $10k pre-tax to his 401k, and pays taxes on the remaining $10k.
  2. He then takes a $10k 401k loan out, and puts the $10k in his bank.
  3. He spends $10k on his wedding, and his bank balance goes down accordingly.
  4. In Year 2, he again makes $20k gross and does not make any additional 401k contributions.
  5. Finally, he pays back the borrowed $10,000 back into his 401k using the money he earned in Year 2.

Scenario #3: Credit Card Loan

  1. In Year 1, Elton makes a total of $20k gross. He contributes $10k pre-tax to his 401k, and pays taxes on the remaining $10k.
  2. He then borrows $10k via his credit card.
  3. He spends $10k on his wedding.
  4. In Year 2, he again makes $20k gross and does not make any additional 401k contributions.
  5. Finally, he pays back the borrowed $10,000 back into his credit card using the money he earned in Year 2. The 401k stays at $10,000 the whole time.

In all three scenarios, the amount of taxes paid is the same, and the final result is the same. Total taxable income over two years is $30k in all 3 cases. Final taxes paid: 25% of $30k, or $7,500. You end up with a 401k with $10,000 of pre-tax money in all 3 cases. No additional taxes are paid by taking out a 401(k) loan.

It does not matter even if he spends the $10,000 borrowed and pays it back later with after-tax money! Thus, I still conclude that there is no “double-taxation” on 401k loan principal.

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  1. Very interesting, and of course you’re right. To boil it down: Money is fungible.

    The real loss is from not having the money in the 401k, earning dividends and capital gains tax free. Of course, that’s only a loss if your 401k investments actually HAVE dividends and capital gains during the time you take the loan…. ;o)

  2. I bet those who took out a 401k loan from equities january 1 and paid it back in full 7 mos later are happy campers. Sold at a high point and dollar cost averaged throughout this bear market. In effect lowering their cost avg in their 401k and made money.

  3. What about the interest on your 401k loan?? Although the rate will be better than a credit card loan, you will have to pay interest on your $10k. When you pay back the principal and interest with after-tax dollars, you still have to claim the interest as income to your 401k account. When you do finally withdraw your 401k, you will again pay taxes on the interest. Hence, double taxation.

  4. Well, then there is the fact that the 401K administrator may charge you fees to take out a loan. That’s what we found out when we wanted to know everything we could know about our 401K options: There is a fee to take out a loan, and then a fee for every year you take to pay it back. I don’t remember what they were, but we thought that they seemed sufficient to make it not worth taking the loan.

  5. Yes, interest is double-taxed, but not loan principal. This leaves your effective interest rate as only the extra tax on the interest being paid back into your 401k. See the “last post” link for details.

    • Well, yes and no… there always seems to be, at least in my mind, a missing component in these discussions.
      No one ever factors in FICA/SE taxes. And at 7.65/15.3(to keep it simple, not net), that is a fair amount that you are paying twice on the “principal” amount.

      What say you?

  6. Regarding double-taxation of interest — if you’re using the loan to pay off higher interest debt (such as credit card), you still make out better with the double taxation.

    For any other debt you pay off, you still are using taxed money to pay the interest. But then you never see that money again.

    For the 401k loan, the interest goes into your account single-taxed. It then has X number of years to increase and multiply, at which time it is taxed again. But at least you get some portion of your interest back in the long run, which is much better than simply paying it to a credit card company.

    Of course, if you’re taking out the loan to pay of low-interest debt, like a mortgage or student loan, or to finance a drug-fueled tour of the Carribean, then you’re not really gaining anything.

  7. Nice job. Good article.

    This is not a taxation game. It’s a personal behavior game. People have been led to believe that these loans are somehow better than using a credit card or a traditional bank loan just because it is their money. I don’t borrow money, but I would borrow from a bank, a credit card, or a life insurance policy before I would even consider the hassles involved with borrowing from my 401k and paying it back.

  8. Not to nitpick or anything, but you can only borrow up to 50% of what you’ve contributed or the vested account balance in almost every instance. So in order to borrow $10k, he would have had to have contributed $20k, or have a vested balance of $20k.

    I know it doesn’t affect the math in question, but it could make a difference in a real life loan decision situation 😛

  9. El Cheapo says

    Jonathan, I think you did a fine job tackling a tricky subject. Especially considering all the talking heads that have ingrained the ‘double taxation’ argument in our collective heads. The party line seems to be ‘don’t touch your retirement at all costs’, but I don’t think the picture is as negative tax-wise as they make it out to be. Is taking a HELOC to pay off debts any better? Because a house is a ‘hard asset’ versus that strange mysterious stock market? C’mon…

    Just to make your life more complicated :D… what about time value of money? Elton’s 10K loan, ie. cash in hand, is arguably more valuable today than the sum of his payments back to the principal plus interest over the course of a year (incidentally, my 401K allows for up to 5 year loans for general loans and 15 years for principle residence loans)

  10. Doesn’t the example assume that the money was put into the 401(k) at the same tax rate as it’s repaid.

    I’ve been putting in money for 18 years, I started in the 15% bracket and now I’m in the 28%

  11. Why doesn’t the amount left in the 401k in your various scenarios grow at all over the two years?

    You aren’t accounting for the “opportunity cost” of lost tax deferred gain on the 401k money you take out in the form of a 401k loan.

    Then go ahead and compound that lost money over the life of your 401k to find the true huge cost of your 401k loan.

  12. To illustrate my point …

    Let’s assume your 401k is invested in a 3% CD. In scenarios #1 and #3 the 401k loan value should be $10,609, not $10,000. Putting a $609 “opportunity cost” on the 401k loan.

    Now, let’s compound that $609 at 3% over the next 40 years, and we find that the true cost of your 401k loan is almost $2000.

    Raise your expected rate of return on the $609 to a historical stock market return rate of 8%, and the cost of your 401k loan is over $13000!

  13. i think i get it, but your table is confusing (eg. each column is per yr except 401k balance?, and there’s two scenario #1’s), which is i guess the reason why you explained the table. i dont understand why this is so hard to grasp, but it sure is making my head spin.

    i dont understand the interest, why do you pay that to yourself? i thought it was to the agency. so the only fee for doing this is the ‘fee’ they charge? for my tsp plan, it’s only a $50 fee to borrow half my balance and the interest rate is 3.875. so i’d have to pay back what i borrow plus 3.875 annualized i’m guessing to my account?

  14. Justjoeguy says

    You set up your own company separate from yourself with its own EIN then set up the 401K. The company pays in the same amount as you do. You then borrow the amount in the 401K put in by the company. Then you use the loan money for some other business or investment. You pay the loan back plus interest. The interest is then deductible. That will offset the double tax on the interest. But you will deduct the interest you pay right now. Whereas the interest you pay into the 401K will not be taxed until you retire and take it out.

  15. J – There is opportunity cost to all loans, 401k or not. What if you borrowed $10k from a credit card and used it to pay down debt? You could have used the money from the credit card to put it into the stock market or a CD.

    If you theoretically took the $10k out of the 401k and put it in the exact same investment outside the 401k, you would be losing a bit of tax advantage during the time it was outside. But you wouldn’t be losing the whole 6% or 8% or whatever. In addition, when you repay the amount, your money is again tax-advantaged. This is another reason why it is important to realize there is no double-taxation or permanent loss of tax-deferred status.

    Exact calculations are complicated. In reality, your 401k is probably is in stocks and could have gone significantly up or down in value since you took your loan.

  16. Jeremy – 50% cap was addressed in original post. 🙂

    gt – Fixed the two Scenario #2 labels. Yes, in 401(k) loans, you pay yourself interest back into the plan.

    Justjoeguy – So, you are trying to artificially increase the contribution limit on 401(k)s, is that it? At first glance, I suppose it could work. The hard part would be to properly justify the “business” loan to achieve the full tax deduction.

  17. Bill – Yes, it does assume constant income tax rates. But only over the life of the loan, which can’t be more than 5 years.

  18. Here’s why this is still double taxation:

    1. The 401(k) was originally all tax-deferred dollars.
    2. The tax deferred dollars were drained out of the account.
    3. It was replenished with dollars that were taxed i.e. it takes $13333.33 to replenish the 401 (k) account.
    4. When withdrawals begin on this portion on the 401 (k), they are taxed again.

    Am I missing something?

    • Mitchell Giesy says

      Entirely correct. Under scenario #2, Elton *has paid the same amount of taxes as under scenarios #1 and #2″ as stated in the example. So now his tax-deferred 401k contains $10k of funds already taxed. Now fast forward to the most important of the double-taxation argument, which was conveniently left out of the present argument: distribution from Elton’s 401k. Under scenario’s #1 and #2, Elton would be taxed – for the first time – on a $10k distribution from his 401k in retirement. Under scenario’s #2, he would be taxed on a $10k distribution from his 401k *for the second time*. (on the $10k loan payback funds)

  19. codeslave says

    The way to look at it is that you don’t pay taxes the first time you’re spending it. If you need 10K for the wedding and take a 401k loan, you just need 10K Gross. If you’re getting it from savings, you need 12.5k Gross, pay the taxes and then get your 10k. No one complains about the fact that you spend the 10k without taxes and them scream OMG, I’m paying taxes twice when repaying the loan.
    Brings up an interesting arbitrage scheme. If I take out a 401k loan and fund a Roth IRA, the interest is tax-free. Sounds like I’m having my cake and eating it too. U think that’s feasible?

  20. As to your statement (3 comments up) about everything having opportunity cost… Don’t forget, everything that has opportunity cost also has “opportunity risk”, for lack of a better phrase. In other words, opportunity cost isn’t really a cost if taking the opportunity would move you above your personal risk threshold. I could borrow as much money as possible and leverage my investments heavily. Not doing so has an opportunity cost, although it is not meaningful because I don’t have a high enough risk tolerance to want to do it anyway. However, I agree with your real point, which is that it opportunity cost matters regardless of where you borrow the money. A loan is a loan. The collateral really isn’t important.

  21. Just to clarify: In the scenario J brought up, what if you also assume you have an additional investment outside the 401(k) that is also in an identical CD. Is it better to borrow against the 401(k) or to cash in the other CD and reinvest over time? That’s what J should be comparing. The opportunity cost is the same for both cases. The fact that one is in a 401(k) is irrelevant.

  22. Jonathan – No only are the principal repayments not double taxed, there’s no double taxation on the interest either. Simply put, the interest on a 401k loan is not tax deductible, just like a credit card loan or a car loan. That’s all. I wrote a post about this double taxation myth in draft, but since you brought it up now, I will just put the gist here.

    Picture this scenario: You borrow from a bank. You pay interest to the bank with after-tax money. The bank pays interest to your 401k because your 401k owns bonds issued by the bank. We all understand that the interest your 401k earned from the bank clearly should be taxed upon withdrawal because that’s investment earnings. Now take the bank out from the middle because it was merely passing the interest earned from you to your 401k. You pay interest with after tax money directly to your 401k. What changed? Nothing. The interest your 401k earned from you should also be taxed. Therefore there is no double taxation on the interest.

  23. TFB – Well, “double taxation” can be a misnomer. The way I see it, you’re effectively making forced after-tax contributions to your 401k when paying interest on the loan (to yourself). Because without this force, you could have been making pre-tax contributions instead, it creates the only effective cost of the loan.

    Since, upon final withdrawal from the 401k, you have to pay interest again, it can be construed as double-taxed, just like an after-tax contribution to a Traditional 401k.

  24. From another website sent to me:

    Many people argue that 401(k) loans are good because you pay yourself back and you pay yourself interest. It is true that you pay yourself interest, but you have to understand the following: When you pay the principal and interest, you are paying in after tax dollars (remember, your contribution to the plan was in pre-tax dollars). So, if you are in a 25% tax bracket, you must earn about $67,000 to pay back a $50,000 loan. In essence, you just lost your tax deduction.

    Wrong, wrong, wrong.

  25. This has been a very interesting set of posts. I wanted to share a view from someone who has actually taken out a 401K loan. My plan allowed me to continue repaying the loan on the original schedule even after leaving the job, so that risk was eliminated. (I did in fact leave my job shortly after taking out the loan.) In late 2004, we were purchasing a home and needed an additional 10K to get our mortgage below the 80% threshold and avoid PMI. This was going to come from some kind of loan, and second mortgage rates were about 2% higher than the 401K rate. I realize that with that tax benefits, a second mortgage would have about the same effective rate as the 401K loan, but I’d rather get double-taxed on the interest then just pay it to a bank and lose all of it. Given what stocks have done over the last 4 years, I think it turned out to be a very good option. I agree that taking a 401K loan has its risks, but it is not an inherently bad idea.

  26. Justjoeguy says

    Jonathan says: Justjoeguy – So, you are trying to artificially increase the contribution limit on 401(k)s, is that it? At first glance, I suppose it could work. The hard part would be to properly justify the “business” loan to achieve the full tax deduction.

    That’s really just part of it. If you set up the plan so that you have to pay back the loan with a 20% interest rate you could get a 20% rate of return guaranteed on the part you take out plus get to deduct all the interest if the investment or business you use it for is structured properly. This certainly can be done. See Publication 550 Investment and Interest Expense. Not to mention the Feds want you to save as much as possible for retirement so they actually like the idea a lot.

  27. Hari –
    Maybe I’m missing something:
    1. The 401(k) was originally all tax-deferred dollars. – CORRECT
    2. The tax deferred dollars were drained out of the account. – CORRECT
    3. It was replenished with dollars that were taxed i.e. it takes $13333.33 to replenish the 401 (k) account. – CORRECT, but you’re using the 10k loan pre-tax which is equivalent to earning $13,333.33… so it evens out
    4. When withdrawals begin on this portion on the 401 (k), they are taxed again. – Withdrawals of the interest are taxed, not the loan… right?

  28. lets say i want to buy a $10k car and slowly save up the money and stuff it under the mattress until i’ve got $10k in after tax dollars. when i buy the car, it really cost me about $12,500… $10k paid to the dealer and $2500 paid to uncle sam over time.

    OR, i could take out a 401k loan for $10k of my virginal, untaxed savings and go to the dealer and buy the car for 10K… and $0 to uncle sam! sweet, i saved $2500! not so fast, says uncle sam, you have to pay it back when you pay back the 401K loan.

  29. To Hari,

    “4. When withdrawals begin on this portion on the 401 (k), they are taxed again.”

    But you would have been taxed upon withdrawal of 401k anyways, regardless of whether you took a loan or not. The bottom line is that there is no additional taxation on the principal when comparing 401k loan vs a standard bank loan. For a bank loan, I could make the same statements:

    1. Repay bank loan with after tax dollars.
    2. When withdraw 401k, you get taxed.

    Is that double taxation? Not really. But if you want to call it double taxation, well, the bottom line is that both scenarios are still equivalent.

  30. I took out a 401k loan as an alternative to using other debt sources. From the 401k investment perspective, I thought of the loan distribution simply as the fixed income portion of my overall portfolio strategy, and adjusted my remaining investments accordingly. In other words, is there really any difference between putting $25,000 into a bond investment that pays you regular dividends versus “investing” it in a loan (that happens to be to myself) which earns interest (in the form of my payments back into my account)? From the borrower’s perspective (also me), I’m simply getting the loan proceeds and paying interest back to a pseudo-3rd party (my 401k fund) rather than to a real 3rd party (a bank or a credit card). Make sense?

  31. hemram4u says

    i am lil bit confused here. simple question:

    Let say I took a loan from 401k. Then when I pay back the loan will that be pre or post tax $$?
    If it pre-tax then there is NO question of double tax;
    if it post-tax then will it be taxed again when i take that 401k later?

  32. Folks, when you take out a loan, you pay it back with after tax money. It doesn’t matter if it’s a 401(k) loan or any other type of loan. Either way, you get the $10k (and pay no taxes on it regardless of the source of the loan), and you pay it back with after tax money. It’s as simple as that. The fact that it came from a 401(k) is irrelevant. Either way, you pay it back with after tax money. Either way, you end up with (roughly) the same amount of money in your 401(k). The only real difference is whether your 401(k) investments gained more or less than you paid in interest. If it made more, then you should have taken a bank or credit card loan. If it made less, you should have taken the 401(k) loan.

    Forget about the tax effects of the 401(k) and just realize that either way you get $10k and either way it gets paid back with after tax dollars. That’s all that really matters.

  33. Wow, this has sparked quite the discussion. I think the essence of the confusion is that Suze Orman, et al. focus only on one half of the transaction. Yes, when you pay back the loan you are essentially funding your 401(k) with post-tax dollars. But, when you take the loan, you are able to spend pre-tax dollars, which you wouldn’t otherwise be able to do. The benefit and the drawback cancel each other out, taxwise.

    There are of course many other reasons not to take out a 401(k) loan – many of the comments here note them. But Jonathan’s right, the tax issue is not one of the reasons.

  34. There are several factors that need to be taken into account to make the best decision. The “double taxation” is an illusion. When you take a loan from your 401(K) plan, the loan becomes an investment of the plan. The money for the loan is made available by selling other 401(k) investments. When you withdraw money from the 401(k), you will be taxed on the earnings whether they came from capital gains, dividends, or in this case, interest on loans.

    Emotionally, it feels like you are being double taxed because you are repaying the loan with after tax dollars. However, you would be repaying the loan with after tax dollars if you took a bank loan or as one person mentioned, used your credit card.

    Taking a 401(k) loan is a business decision and should be made like any other business decision. What is the cost of the loan compared to other funds available? What is the interest I am “earning” on the loan compared to other investments available in the 401(k) plan? Do I really need this thing that I am borrowing money for? Am I jeopardizing my retirement income by taking this loan? When stocks are growing at 20-25% per year, a 401(k) loan is expensive. When the market is down, like it is now, you may actually be increasing your return on investment by “investing” in a loan. Of course, if you default on the loan repayment, you will trigger a taxable event including a penalty tax. This risk factor should also be considered when determining the best source of funds.

    There is one other factor that needs to be considered here. If my choice is between curtailing my 401(k) contribution to increase my cash flow, or continuing to contribute at a high level and borrowing part of my existing accout balance, I may be better served by taking the loan. If I don’t maximize my contribution this year, I will never have an opportunity to go back and make up those contributions. In the end this could be much more costly than a short-term loan.

  35. Thanks for discussing this Jonathan! I totally agree with you and it was something that Suze Orman said that always bothered me (but I like her usually). 401k loans are fine, and not bad at all, when used responsibly. You get a low-interest rate loan, part of which goes towards your own retirement, and the rest, taxes. Just like everything else in your 401k. The problem only comes when people don’t pay back the loans and they go into default.

  36. Good discussion, thanks for posting this. 401k loans are not double taxation. This is also one of my pet peeves about Suze Orman.

    Any loan you pay off is going to be after tax dollars so you’re no worse paying off a 401k loan or a bank loan or credit card.


  37. JoeTaxpayer says

    You did a good job to debunk the double taxation myth.
    Putting aside the risk of job loss while the loan is out there, I look at three things:
    A) Expected return of 401(k) account balance
    B) Alternate cost of funds, i.e. other loan interest
    C) 401(k) loan interest rate.

    If your credit cards are 18%, and the 401(k) loan, 8%, a $10,000 loan will return an extra 10%. So to keep things apples to apples, you should take the extra $1000 interest you saved and deposit it to the 401(k). But since those deposits are pretax, it’s really $1333 you’ll put in that account. Plus the 8% you had to pay back. So on the loan you took, the account thinks you paid it back 21%.
    Lest anyone think this is smoke and mirrors, by doing this, you are out of pocket the same amount. But instead of paying Visa 18%, you pay it to yourself.

  38. Hey guys. I’ve been reading this blog for a long time now, but have never posted. However, I felt compelled to add my 2 cents.

    I read through the two posts on this topic and the comments and I’m not sure why this is be being dismissed as a double taxation event. For simplification, I have created a couple of pictures that show my thinking on this topic. Please review and let me know why you believe it works differently. My example assumes a constant tax rate of 25%.

    Step 1
    Step 2
    Step 3

  39. I believe what you’re missing here, Jason, is that the $10,000 originally contributed to the 401k was contributed pre-tax. For it to be double-taxed, when you originally withdraw the $10,000 you would arguably only get $10,000 minus taxes rather than the full, pre-tax $10,000 that you originally contributed.

  40. I’ve been thinking about this and I can think of one scenario where the 401k loan could be (short term) beneficial. At bonus time a 10-15% tax can double or triple. If you are planning on taking out a 401k loan the timing around your bonus could be worth a look. Of course it all comes out in the wash at the end of the year, but if you get you bonus in Jan or Feb….. I could be missing something but I’ve always wondered about that.

  41. Taxation on the money used to pay the interest going into 401k and on withdrawal of the same money. (Double taxation.)

    Say you take out $10k loan from a 401k and have a rate of 6%. Say you are in the 33% tax bracket now and when you retire. For simplicity sake, let us say that your money doesn’t grow in 401k account. Also, presume you pay the interest in a single lump sum at the end of the year. $600 interest that has to paid back at the end of the 1st year. This money was obtained from $900 that you earned and paid $300 taxes on. Given that we are presuming there is no growth and you are still in 33% tax bracket when withdrawn. The withdrawal of this $600 will result in $200 being given to taxes. That is a total of $500 from the $900 you earned going to taxes (not just the $300 first time around but an additional $200 on withdrawal). Please do not say there is no such thing as a double taxation on the interest. Instead say that depending on what you use the loan for, it may be a good idea overall.

    I reiterate, just cause the interest is double taxed doesn’t mean there aren’t situations where it may be a good idea to take the 401k loan. Even if the amount was used to pay off a home loan where interest would have been tax deductible, it may still be a better idea. e.g. Say 6%APR interest only home mortgage. Instead of paying the tax-deductible home loan interest of $600 to some unknown bank, by taking out a 401k loan for the $10k you would only be losing $500 ($300 now and $200 on withdrawal) to taxes from your income instead of losing $600 of your income to your mortgage company. (I am unclear as to whether or not the interest portion of a 401k home loan taken out for your primary residence mortgage is tax deductible. In which case, you would not be losing $300 when you pay the interest to the loan.)

    Lots of variables including your tax bracket now and on retirement, purpose of the loan, anticipated growth in your 401k, etc., can complicate the choice further.


  42. That is a useful article, here’s how another financial advisor puts it in the way of 401k loans.

    When you borrow from your 401k(k) plan, there are no costs associated other than the interest that you repay yourself. You do not have to pay the extremely high Credit Card APRs, late payment fees, overdraft interest, etc. When you log in to your financial services company’s website you specify from which investment you want to withdraw money from, and that investment is liquidated for your specified amount. Thus, you will be losing any positive gains you would have made if you had left your money intact in the investment, this is the disadvantage. However, you also avoid any losses that that investment might have made. You will realize there is an opportunity cost associated here. The cost of borrowing from your 401(k) plan versus borrowing from a credit card is:
    401(k) Loan Cost Advantage = APR Charged on Credit Card Withdrawal – Investment Gains on Withdrawn 401(k) loan

    For instance, if you borrow a loan from your credit card company at 15% APR, versus if you borrow from your 401k plan where you are currently returning 9% a year, the cost advantage is:

    401(k) Loan Cost Advantage = 15% – 9% = 6%

  43. I’ve been thinking about the double taxation on the interest, and I think unless I’m missing something quite obvious, it’s a terrible argument against taking a 401k loan. If you take a 401k loan, the money you pay interest on the loan with is first taxed, then invested where presumably it will earn returns, then taxed again (including the returns) when withdrawn at retirement. If you take a loan from another source, the money you use to pay interest on the loan with is first taxed, then GONE. You gave away 100% of what was left after paying taxes on it. It does not earn any returns for you. It does not matter what your tax rate is, any percentage of $0 is $0.

    Assuming a 25% tax bracket, would you rather pay 25% on $1000 earned now leaving you with $750, then pay %25 on the $750 later leaving you with $562.50, or would you prefer to pay %25 on that $1000 now, and simply give the remaining $750 away to someone else, leaving you with $0? For every $750 interest you pay into your $401k loan, you come out $562.50 ahead, and that’s not even counting any returns you would have made on $750 over time. Taking this furthur, assume 8% annual return over 20 years and that $750 would become $3495.72. After paying 25% taxes you are left with $2621.79. Take the loan from another source and you are left with $0.

    Am I missing something here?

  44. and just in case anyone is still reading…thinking about it more I think I was missing the fact that if I don’t take the 401k loan my account would have earned the same $750 over the loan period if the loan interest rate is equal to the market rate of return.

    I think it’s a wash – with the 401k loan you pay the interest to yourself, with after tax dollars that are taxed again on withdrawal. With another loan source the interest comes from the market and is taxed on withdrawal, but I’m still paying the interest on the outside loan with after tax dollars. Either way I’m paying interest with after tax dollars AND the gains in the 401k are taxed on withdrawal. Still no basis for an argument against a 401k loan. In fact it may be an argument for one, if trading an unknown rate of return for a known one is considered a good thing.

  45. Andy — I am still reading and agree…as I mentioned in a previous post, I view it effectively as a fixed income allocation in my 401k. In other words, my 401k is essentially buying a bond that gets a specific rate of interest and principal repaid over a period of X years. It just so happens that I’m also the one paying back that interest and principal. But as you point, out if I wasn’t paying myself with after tax dollars, I’d be paying someone else with those same dollars. If you can live with the fixed return level on the loan in your 401k vs. the potentially higher (or lower) returns in the market, then I think it could absolutely make sense to take the loan.

  46. I agree with the post, but another perspective for those who still insist on double taxation is that there’s no difference between paying tax twice on the same 401k dollar vs paying the tax once and that dollar and also paying tax on the dollar you paid back to the bank.

  47. 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.

  48. There were some great points in this thread. In certain cases of high interest debt, I would agree whole heartedly. BUT there is something to consider.

    Your bank loan is done after you pay the loan with post-tax dollars.

    Your 401k loan money is taxed again after the loan is completed. So in theory you paid yourslef back the 6% only to pay 20% in taxes when the money comes out. Assuming you are in a lower tax bracket when you retire, so in essence you lost 14% on every dollar you borrow.

    I’d love to see a spreadsheet of the numbers calculated over a real period of time.

    In the, there is only 1 real winner. Uncle Sam. He makes money either way you do it.

  49. Wow! How times have changed in 3 years! If someone took out a 401K loan back in 2008 – they would be much BETTER off than if they would have left it in the stock market! Jonathan needs to write an update in today’s market.

  50. Chan is incorrect.

  51. 401K loan rocks, Suze Orman sucks noodles.

  52. IN example #1, if there’s no loan, why did his taxes go up in year 2? also , how would the person know his future tax rate? As far as I can assume, taxes have been going up and may continue to do so. It doesn’t seem like there’s a “wash” in this.

  53. #1 tax figure is wrong says

    jjj is correct. The figure in #1 is incorrect. In the 25% bracket on 10,000 taxable dollars you would pay $2500 which would equal $5000 total. Therefore, this scenario is very inaccurate and explained incorrectly. There is a form of double taxation and if you do the math correctly it is shown. Unfortunately the creator did not calculate these figures correctly or chose not to trying to state his case.

  54. #1 tax figure is wrong says

    sorry jumped the gun. Scenario #1 assumes the person stops making contributions. I thought he was still making contributions and saving for the ring. So the math is correct in that aspect.

  55. where is retirement scenario says

    After much debate and consideration this is still incorrect and there is a form of double taxation. The double taxation occurs in retirement. He is correct on repaying the loan today will not make a difference right now. When he takes out the funds at full age of retirement he will be taxed on the $10k again which means he will be paying an additional $2500 (assuming 25% bracket remains) for $10k total in taxes paid.

  56. But doesn’t the double taxation come in when you retire and start taking taxable distributions? Because, from a 401k, all distributions. When I think of ‘double taxed’ money, I don’t think of it the way the author did here.

    I think about down the road when you paid that loan back with after tax money, and then get taxed at the income rate when you take a distribution at retirement. How is that not considered double taxation?

  57. Even ADP perpetuates the 401k loan double tax myth in their loan information doc:

    “Borrowing from your plan savings could cost you – twice.
    When you take a loan from your retirement savings, you repay both the principal amount of the loan and the interest with after-tax money. Once you begin withdrawing money from your account at retirement or attainment of age 591?2, the amounts you previously repaid in the loan are taxed again. Under the right circumstances, taking a loan may be right for you, but it’s important to understand the tax and other financial consequences.”

    Is this misinformation driven by money or ignorance?


  58. I love Suze but her double taxation argument is just wrong.

    Let’s say I have $1M cash in savings post taxation. Money no problem. And I want to buy a boat for $10K.

    If I buy the boat with savings it means I bought a boat with post tax money.

    If I borrow $10k from my 401k and pay it back with post tax money, how is it different? Yea there is some interest but that’s not at issue here.

    There are reasons not to borrow money from your 401k but the double taxation excuse is just bogus and Suze needs to stop repeating it. It confuses people because it “sounds right” but in fact it isn’t.

  59. The double tax argument makes no sense. The answer is so simple.

    1. Let’s say I have $10,000 in my IRA. Then suppose I borrow the $10,000. I am now up $10,000 in cash.
    2. I now take this $10,000 and immediately put it back into the IRA.
    3. Then I retire and pay taxes the IRA when I divest it. I have only paid taxes once.

    I don’t pay taxes on the $10,000 when i take out the loan because it is not gain to me.

    I think the whole double tax controversy comes from the idea that when I pay back the loan I am paying myself back in after tax dollars. Then when I take out the money from my IRA I am getting taxed again.

    In other words
    1. I have 10k in my IRA; I take out 10k loan.
    2. I literally throw the 10k into the fire.
    3. I now have to pay myself back with 10k from after tax dollars.
    4. I retire and now the 10K paid with after tax dollars is taxed again when I divest the IRA holdings.

    in this case you are getting DOUBLE TAXED. But this argument completely forgets the fact that upon taking out a 10K loan, I now have an extra 10k in cash with which I can repay said loan.

    In other words by taking out a loan against your IRA, you are only getting double taxed on every dollar you pay IN ADDITION to the amount you receive from your loan. I.e. the loan interest.

  60. 401(k) contributions are made using pre-tax dollars.

    401(k) loan repayments are made using after-tax dollars.

    This is where double taxation comes into play.

    Scenario #1
    You invest $10,000 in your 401(k), pre-tax, and never request a loan. When you request a distribution you pay taxes on that $10,000 plus any gains.

    Scenario #2
    You invest $10,000 in your 401(k), pre-tax, and take out a $5,000 loan. You loan repayments are made after-tax so you are paying taxes on the $5,000 principle plus the interest being paid on the loan. Once the loan is paid off and you request a distribution you are paying taxes on the $10,000 you invested plus any gains.

    So in summary, the double taxation comes from paying the $5,000 in loan payments + interest after-tax and then being taxed again on your distribution from the plan.

  61. Westside Financer says

    New comment on a really old thread but just feel like I need to give my semantic insight. The whole “double taxation” argument to mostly bogus in my eyes. The first thing I think that loses people is the disconnect on how loans are repaid. It doesn’t matter if I take a loan from my 401(k) (consider this entity “future you”), a bank, HELOC, or rack up credit card debt to finance my purchases, the principal and interest must be paid back with “after-tax” dollars. In all the potential funding vehicles, you can’t pay any loan with pre-income tax dollars. You work a job, you get a paycheck with FICA, payroll taxes, and income taxes taken out. After which, I can now repay my loans.

    If I take out $10000 with 0% interest, and over a year, pay it back into my 401(k), it’s no different than any other loan with 0% interest (disregard the gains “future you” would have on the money for now). Let’s reuse the previous example with some arbitrary interest rate of 5% and an arbitrary tax rate of 25% now and in retirement. That $10000 loan is repaid with $500 of interest, for a total of $10500. The only portion that is additionally taxed is that $500, since you paid taxes out of your paycheck to pay interest with any other loan, plus when “future you” withdraws that $500 in retirement. In total, your net cost of the loan is only $125 (25% of $500). If you took out a conventional loan, your cost is $500, minus any tax benefits for interest deductions if they exist (max $125 if used for that purpose), leaving a loan cost of $375-$500. Assuming no gains in your 401(k) or from the money withdrawn and you won’t encounter 401(k) loan risks, it’s smarter to take out a 401(k) loan than a conventional loan as would you save $250-$375 in loan costs for this example.

    Where it gets complicated is when other loans have differing interest rates, your 401(k) portfolio does indeed have gains or losses, and tax rates in retirement, the later two being unknowns since you don’t know how your portfolio will perform or what income taxes will be in 20+ years. In this case, to get a true benefit calculation, here is the comparison formula:

    (401k principal * gain/loss rate on investments) + (taxes paid on 401k loan interest over life of loan) vs.
    (loan interest over life of loan) + (loan costs and fees) – (tax deductions on loan interest)

    Let’s use the above example, plug in some variables with 20/20 future sight. The gain on investments are 8% ($800), the conventional loan is 6% ($600), an origination fee of 1% ($100), with no tax deductions.

    ($800) + ($125) <= ($600) + ($100) + ($0)? NO. In this case, take the regular loan!

    But in a situation like credit card debt, let's change the interest rate to 20% ($2000) with no fees or tax benefits.

    ($800) + ($125) <= ($2000) + ($0) + ($0)? YES! Stop paying high credit card interest and MAYBE take the 401(k) loan, recalculate with a comparable conventional loan and see if it still makes sense.

    Where it gets further complicated is if you might quit or be fired or fall into one of the other 401(k) risks that require immediate repayment, avoid a 401(k) loan at all costs.

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