401(k) Loans: Double taxation or not?

[Guest InTraining]

Anyone want to weigh in on the topic of 401(k) plan loans and the often quoted double taxation of these amounts - in that the loan is paid back with after tax dollars?

There seem to be two schools of thinking:

1. Exactly as summarized above; loans taken out are paid back with after tax dollars which will be again subject to tax upon distribution of these assets at retirement/other.

2. Not sure I understand this school, but I believe it is argued that you were given access to these funds and were able to use them - as opposed to other resources - and somehow it is argued that the "double taxation" does not exist.

Oddly enough, it's almost a 50/50 split around here.

Anyone else?

[jpod]

Think of it this way. If the plan made a "legitimate" investment by loaning $10,000 to a 3rd party, the interest paid on that loan become part of the plan's assets and would be pre-tax to the participant.

So, instead of lending $10,000 to a 3rd party, the participant takes a loan for himself for $10,000. The interest is treated the same way because the loan is to be treated as if it was a "real" loan.

[mbozek]

I am somewhat at loss to understand the question -- Since taking out a loan from a 401(k) plan is a tax neutral transaction, e.g., the loan is not a distribution, the repayment cannot generate a tax benefit to the participant. There is no double taxation since the money has not been taxed upon the payment of the loan amount. Allowing a deduction provides the borrower with a double tax benefit. Also under the law only contributions to the 401(k) plan are deductible. By analogy a loan from a 401(k) plan is no different than a margin loan from a brokerage account-- the participant is borrowing from the assets without being taxed on the loan proceeds and agreeing to pay back the funds to his/her own account. Pror to 1987 interest paid on 401(k) plan loans was deductible but congress chose to eliminate the deduction for personal interest as part of the 1986 tax reform act.

[MGB]

Double taxation does not exist. If you were taxed on the loan distribution and paid back with after-tax money, then you would have a valid argument. But, you received the loan proceeds without taxation so that there is no double taxation. I don't even see a single level of taxation. As mbozek said, this is a tax-neutral transaction. Whatever you spent the proceeds on, you would have spent after-tax money on it anyway (assuming you just waited until later to pay it). By taking the loan and then paying it back with the funds you would have used for the expenditure anyway leaves it as a tax-neutral transaction. The fact that the paid-back loan will be taxed at retirement is irrelevant. That taxation would occur with or without the loan. When I was in a doctoral program on the economics of taxation, we often picked apart numerous transactions for their actual affect on all parties and this one is an easy one -- it is tax neutral.

However, there are some hidden effects under the auspices of opportunity cost or gain. This is when the interest rate is different than what the funds would have earned in the plan if they had not been loaned out. But, that is a subtle, small effect and was not the original question.

[BFree]

You are double-taxed on the interest paid. You pay back the loan proceeds plus interest with after-tax dollars. Upon distribution from the plan, you are taxed again on the already-taxed interest from your loan.

[MGB]

Assume the fund would have earned the same return as the interest rate paid. (I alluded before to there being some affect if these two are different.) Then, in retirement, whether or not you took the loan, you pay the same tax. Taking the loan does not increase or decrease that taxation. Therefore, it is a tax-neutral transaction from the standpoint of the retirement fund.

If you had taken an external loan for the same transaction, you would be paying for that interest with after-tax dollars (unless it happens to be a tax-deductible loan such as from home equity), so that, again, it is tax neutral currently, too.

[mbozek]

I think some people are misconstruing the term double taxation when the term should be non taxed advantaged . Double taxaton occurs when the transaction is subject to two sepraatete taxes, eg. reversion of pension surplus is taxed under both income tax rules and 50% reverson tax or death distributions from pension plans are subject to both income and estate taxes. The repayment of loan interest is a non taxadvanged event the same as the repayment of interest to a commercial lender or credit card company with one difference :the after tax interest is used for the benefit of the borrowor not a profit for the lender. Allowing a tax deduction for the interest provides a double tax benefit not available to other loans in the tax law. Also the treatment of loan interst in a qual plan is no different the the treatment of loan interst on funds borrowed from a LI contract which is not a commercial/buniness loan. Also interest from a 401(k) loan is deductible in one instance: if the loan is used to purchase a residence and the loan is secured by a mortgage on the property.

[BFree]

Let me expand upon my example and let you tell me where I am wrong.

You take a loan for $1,000.

You pay back $1,050 after one year (principal and interest).

The $50 interest that is now in the plan: How did you originally come up with it? - It was after-tax money deducted from your paycheck.

That same interest - how will it be taxed upon distribution from the plan when you retire or terminate employment? It will be taxed as regular income.

Double-taxation?

[MGB]

You are isolating only part of the transaction and not looking at all effects. Yes, in isolation, that money is taxed twice.

However, you are ignoring the return on the plan investments that would have been there had you not taken the loan. That money would have been taxed at retirement. You no longer have that taxation...it has been replaced by the loan interest. You are still paying exactly the same tax. The tax on the loan interest at retirement is not additional tax, it is the same tax you would have paid without the loan. By looking at the loan cash flow in isolation, you are treating it as an additional tax, but it is not. There is an equal and opposite saving of tax from the income you would have had that you do not now have. There is absolutely no additional tax paid whether you take the loan or not when you look at all cash flows (except for differences in the rate of return that you replaced with loan interest).

[Guest stryan]

All these wonderful arguments are starting to make my head spin.

However, I continue to have a difficult time understanding how replacing $10,000 pre-tax dollars in my account with $10,000 (plus interest) of post-tax dollars is not economically disadvantaged.

[BFree]

The $10,000 in and out is a wash. You just bought something with your loan proceeds, and those proceeds had never been taxed.

The interest on the loan is taxed before it is put in the plan and when it comes out of the plan. (As opposed to interest you would have earned if you left the $10,000 in the plan in the first place. That interest is taxed once - when it leaves the plan).

[mbozek]

Free: You have given us a new illustration of an urban legend in employee benefits. You are confusing the source of the repayments with the fungibility of the participants disposable income used to repay the loan. The fact that the loan interest is paid back through payroll deduction does not mean that it is double taxed- the method of repayment is a choice (even if the choice is made by the plan administrator), because the interest payments could be made with interest from a savings account or even interest from a municipal bond but that does not change the fact that the individual's disposable income from all sources is unchanged after the repayment. The funds used to repay the loan are fungible--- the source of the funds used to repay the loan does not change the economic effect that the participant must repay the amount due on the loan with disposable income whose tax character is the same regardless of the funds used to repay the loan. If the participant terminated employment and continued to repay the loan with retirement benefits it does not mean that the benefits are double taxed. The use of the benefits to pay the loan off is a choice of funds by the participant but does not change the economic effect of paying off the loan and the taxation fo the benefits to the participant. Similarily using municipal bond income to repay the loan would not mean that there is a double tax benefit to the participant because the disposable income after all taxes are paid is the same regardless of the source of funds used to pay off the loan. The fact that an employee with $3,000 in compensation can make a deductible IRA contribution with dividend income does not mean that the dividends are tax deductible - they are taxed as income and the deduction is taken from compensation. The source of the funds used to make the contribution is fungible and does not effect the economic result of the transaction.

[2muchstress]

Well, to summarize the original question.

The overwhelming majority believe that there is no double-taxation on participant loans (at least for the principal balance).

There seems to be some aregument as to whether or not the interest is double-taxed.

The original post mentions a 50/50 split. I just don't understand how somebody could say the loan repayment is double-taxed.

The interest being double taxed is arguable, but at least there seems to be some foundation to the argument - not there with the principal portion though.

I'm glad this chain was started because I have tried in vain to convince a few people that loans are not double taxed, and some people just don't get it.

[BFree]

I thought about mbozek's reply for awhile, and while I understand well the "fungibility" of money, the last couple responses were a bit theoretical for me. Perhaps we are talking past each other in not addressing the same question (and I think this may the case).

Money you put into a 401k plan that is put in on a pre-tax basis lowers your current taxable income. Money you put into a plan on an after-tax basis does not lower your taxable income. All other things the same, it is better to put money into the plan on a pre-tax basis. Interest payments are not deducted on a pre-tax basis and a dollar amount paid in interest to a plan is not worth the same as that dollar amount paid in 401k deferrals.

I don't think that qualifies as an urban legend, and I would submit that it addresses the original question (although perhaps not exhaustively)

Now, a participant may not have unlimited funds and may be restricted in where he gets his money. But that goes back to fungibility...

[mbozek]

Free: interest on a 401(k) plan loan is non deductible if the loan is used for personal expenses. Loan interest is deductible if the loan is secured by a mortgage on the participant's residence or if used for a valid investment purpose, e.g., purchase securities, to the extent permitted under the rules for margin loans. But this deduction is the same regardless of the source of the funds used, eg. if the taxpayer put an equal amount of money into a brokerage account and bought stocks, the deduction for margin interest the economic result would be the same.

[BFree]

mbozek - I think that given their frequency of use, discussing mortgage loans made out of plan does not address the general question as a participant poses it.

I concede that if you secure your loan within a plan with your home, you may be able to deduct the interest. Just stating this point makes it clear that some plan loans are more valuable than others. If some are more valuable than others, they cannot all be equivalent on an economic basis.

Loans from a 401k plan are often touted as "paying yourself back." For that reason, a plan loan should not be compared to another investment inside the plan. (As contained in the argument where the earnings inside the plan - if the loan is not taken - are compared to loan interest).

A loan costs money - interest. Of course, taking a loan is going to cost more money than not taking a loan. So, a plan loan must be compared to some other kind of loan.

A plan loan is rightly compared to loaning yourself money outside the plan. When you pay yourself interest outside the plan, that interest is a certain amount. When you pay yourself interest, AND you have run that interest through a qualified plan, what you will get upon distribution is a certain amount less taxes. Thus, plan loans are not equivalent to their "outside the plan" equivalent.

[maverick]

I've learned a lot from this scholarly exchange. I now understand the double-taxation deal -- it only applies to the loan interest (paid to the plan with after-tax $$, then taxed upon distribution).

Apropos of nothing (I saw that in a W.E.B. Griffin novel), another negative about loans is the up- front processing free. People are willing to pay a $150 fee to get a $1,000 loan. They'd probably get a better deal going through one of those paycheck advance places. One guy applied for a $400 loan (not approved because the minimum loan was $1,000) and had "no problem" with the $100 fee.

Thanks.

[actuarysmith]

How are you "disadvantaged"? If you had not taken the loan, you would have had to come up with $10,000 after-tax dollars to buy whatever it was you spent the loan proceeds on in the first place. Same difference.

At the end of the day, you have a 401(k) account, yet to be taxed, and something else valued at $10,000.

The only difference that I can see is whatever the opportunity cost is of the dollars earning the loan interest rate versus whatever the investment returns would have been in your 401(k) account on those dollars. (Right now, not much!)

[Kirk Maldonado]

I agree with ActuarySmith.

[BFree]

Since two of you weighed in...

Actuarysmith and Kirk are comparing investments within a plan. Of course, keeping your account balance in a higher-performing asset is better than keeping your account balance in a lower-performing asset.

In any case, actuarysmith's statement is not true because the "loan interest rate" that the loan earns is not earnings to the individual at all. It is the participant shifting money from one pocket to another. Hence, my call above to compare a plan loan to a loan outside the plan where you pay yourself.

[austin3515]

MGB and Bozek. What you're saying is totally jiving with me. It makes perfect sense.

All the answers are already out there. Let it lie.

[Guest jmarini]

I know this is one of the tiredest, deadest horses in our business and I hate to even ask this question, but I can't get past a certain point in thinking about this. Here's the scenario:

A participant puts money into a 401(k). This money is obviously not taxed when it is put in. He later takes a loan for, say, $5000. The loan proceeds are not taxed when paid to him, of course. Here's where I run into trouble: to pay back the $5000 loan the participant uses after-tax money - depending on his tax bracket he must earn, say, $7000 to pay back the $5000. So the $5000 he puts back into his account is really $7000 with taxes taken out of it. Then when the participant retires he withdraws his account balance, part of which is that $7000 he earned that was taxed down to $5000. When he withdraws it at retirement, the $5000 is taxed again so that it is reduced to about $3500.

Where am I going astray in my thinking?

[MGB]

You have not factored in what happened to the $5,000 he borrowed. What was done with that? If he hadn't borrowed it, he would have needed to use ($5,000 + taxes) to accomplish the same thing. It is this "+ taxes" that everyone misses and offsets the taxes that you are focused on.

[Guest rmeigs]

I think the problem comes with the term “double taxation” when what most people are really talking about is whether taking out a plan loan is “tax neutral.” Another way of asking the question is “Are you paying more taxes by talking a plan loan than you would if you borrowed the money from some other source?”

The answer is that taking out a plan loan is tax neutral. You do not paying more in taxes than you would if you borrowed the funds from some other source. The money is not taxed when it is borrowed. Yes, the payments come from after-tax money, but so would any other payments made on a non-plan loan. You can simply pay yourself the interest or pay the bank. And the fact that the paid-back loan will be taxed at retirement is also irrelevant since earning on those dollars would be taxed regardless of how they were invested. That taxation would occur with or without the loan.

Lets look at a simple illustration.

1. Loan from 401(k) for $10,000 at 5% for five years.

Loan is repaid with after-tax dollars.

Earnings on the loan taxed at retirement.

2. Loan from a bank for $10,000 at 5% for five years.

Loan is repaid with after-tax dollars.

Dollars in 401(k) were not borrowed, therefore they are still invested and earning income (for simplicity, let say the assets earned 5% over the five years). Earnings on this income is taxed at retirement.

As you can see, there is no tax disadvantage to a 401(k) loan verse a non-401(k) loan.

[Guest pjb]

Just to add my 2 cents: There is no other way to borrow from yourself than through a retirement plan, at least that I can think of. Perhaps this is why you're not coming to agreement. The law could have provided for no interest on participant loans based on the idea that it's the participant's money and not the plan's money. I would argue the basis of the law was not to make the plan whole by making up for lost earnings, but to discourage loans or to at least not make them more attractive than other loan options. Since you are essentially paying yourself interest, the law could conceivably be changed to track the interest as an after-tax source. Although this would be an added burden to the plan administrator.

[Brian Gallagher]

One of the people at my company gave (what I thought was) a great example of why the loan (principal, at least) is not "taxed twice":

Say you took a $5000 loan and cashed the check and got 50 $100 bills. payments are to be $100 each (we'll assume no interest for simplicity).

What if you just took that money and put it on a table in your house? Then, every two weeks, you took a $100 bill and mailed it in. After 50 payments, you have paid back the loan and not a single dime of it was taxable along the way.

[pmacduff]

a note to pjb - in the old days a plan participant loan was in many instances (per the Plan Document) considered a plan investment and the loan interest was actually paid back to the plan as a whole and shared among all participants. I think the modernization of plans and the advent of individual participant accounts (where the loan was taken directly from the participant's funds) led to the more common way now of "paying yourself" back. So, in the past, the interest rate would have had bearing on the plan as a whole and impacted all participants. Just an FYI from an old-timer......

[E as in ERISA]

I agree with all of those who say it is essentially tax neutral. To me, the decision of whether or not to borrow from the plan is based primarily on two factors: rate arbitrage and whether you intend to say with your employer during the repayment term.

E.g., if your plan assets are growing at 5% and the plan and bank are charging 5% interest for a loan, it doesn't matter a lot what the source of the funds is. Either way, at the end of the loan term the plan assets will have grown 5% while your assets outside the plan have been reduced (on a net basis) by the 5% interest you paid. Compare that to a case where your plan assets are not growing and the plan and bank are charging 5% for a loan. You may be better off borrowing from your plan. The plan earns 5% while you reduce your assets outside the plan by the 5% interest. (If you had borrowed from the bank, the plan would have earned nothing, while you reduced your assets outside the plan by 5%). Then compare it to a case where your plan assets are growing at 10% and the plan and bank are charging 5%. You may be better off borrowing from the bank. Your assets in the plan will be 10% ahead, while you've only reduced your assets outside the plan by the 5%. (If you had borrowed from the plan, it would have only earned 5% for that time, while you reduced your assets outside the plan by 5%). Of course, this all depends on your ability to predict the markets and foresee what your plan earnings rate will be during the next five years.....But three years ago when markets were sluggish and interest rates were 9%, plan loans had some appeal....

However, you always need to consider that whether you may leave your employer before the maturity of the plan loan and repayment will be accelerated.

[BFree]

rmeigs, I have added the two phrases in parentheses to your example. I cannot square them with your tax-neutral stance. Can you elaborate?

1. Loan from 401(k) for $10,000 at 5% for five years.

Loan is repaid with after-tax dollars.

(previously taxed) Earnings on the loan taxed at retirement.

2. Loan from a bank for $10,000 at 5% for five years.

Loan is repaid with after-tax dollars.

(never-taxed) Earnings on this income is taxed at retirement.

[E as in ERISA]

BFree --

What are you thinking is the difference between your two scenarios? You say that the loan from the plan is paid with "after-tax dollars. (previously taxed) Earnings on the loan taxed at retirement." Then you say the loan from the bank is paid with "after-tax dollars. (never-taxed) Earnings on this income is taxed at retirement." What is "never taxed"? You don't end up with any excess from the bank loan. You get $10,000. You pay the $10,000 back, plus you pay them interest. You have paid out more than you took in. (Did you think that you were going to end up with more than you had started with -- and that the excess outside the plan is not taxed -- while the excess inside the plan is taxed at distribution? Sorry, but the bank ends up with the excess and it is taxed on it.)

Also note that when you do financial analysis, you have to look at the impact on all your resources, consider opportunity costs, etc. So when you consider the bank loan you have to consider what is happening to the assets in the plan

[BFree]

Katherine, thanks for the reply. Essentially, you indicate that there is no difference in the two scenarios - and I'll take that as a genuine reply, even if I don't agree.

To answer your question: "never taxed" is just that - 401k contributions and their resultant earnings inside a plan.

But you also say that the bank is taxed on those earnings. That is of no consequence to a plan participant analyzing a plan loan. As such, that cannot be the basis for stating that there is no difference in the two scenarios.

Your last paragraph is well-taken, although I don't think it is relevant.

[Guest rmeigs]

BFree ---

Your error is that you assume the interest income on the 401(k) loan has been taxed. It has not since a 401(k) is a tax deferred account. All tax on investments income is deferred until withdrawal. At the time of the loan repayment, you did not have to declare the interest income you paid yourself -- it was deferred.

1. Loan from 401(k) for $10,000 at 5% for five years.

Loan is repaid with after-tax dollars.

(never taxed) Earnings on the loan taxed at retirement.

2. Loan from a bank for $10,000 at 5% for five years.

Loan is repaid with after-tax dollars.

(never-taxed) Earnings on this income is taxed at retirement.

[BFree]

To illustrate double taxation:

I take a loan for $10,000 from a plan. I don't spend it.

I earn $600 in the year. That earnings is taxable. Net of taxes, I have $500.

I pay $10,500 into the plan, representing principal plus interest; payment in full.

I need $500 the next day. I go to the plan and withdraw $500. I like to compartmentalize. The $500 I withdrew represents the interest on the plan. I receive $500 and it is treated as ordinary income; the end result is I don't have $500 anymore, I have some lesser amount. My $600 of earnings for the year has now been taxed as payroll income and as retirement plan income.

-----

So, while I agree there may be no tax disadvantage in comparing a 401k loan and a non-401k loan, I don't think you can dismiss talk of double taxation as invalid or equate the two issues. I forget what the original question was. If I diverted from one issue to another, I apologize.

[ccassetty]

I agree with BFree that there is "double taxation" for lack of a better term, on the loan INTEREST but NOT on the principal. The bottom line I keep coming back to is that whatever the source of the money the participant uses to pay back the loan, in most cases, it has already been taxed at some point, even if not in the year in which it is used to pay back the loan. But rather than create a tax basis in the participant's account, it is taxed again when it comes out. I haven't read anything in this thread that convinces me otherwise.

Granted there will be exceptions since some types of income from which the participant could take the loan payments are tax free such as income from municiple bonds and the death proceeds from a life insurance policy, but absent these, I believe that the interest on a participant loan is taxed twice.

[ccassetty]

I agree with BFree that there is "double taxation" for lack of a better term, on the loan INTEREST but NOT on the principal. The bottom line I keep coming back to is that whatever the source of the money the participant uses to pay back the loan, in most cases, it has already been taxed at some point, even if not in the year in which it is used to pay back the loan. But rather than create a tax basis in the participant's account, it is taxed again when it comes out. I haven't read anything in this thread that convinces me otherwise.

Granted there will be exceptions since some types of income from which the participant could take the loan payments are tax free such as income from municiple bonds and the death proceeds from a life insurance policy, but absent these, I believe that the interest on a participant loan is taxed twice.

[Guest jashendo]

I've just read through this thread for the first time, and though I refuse to beat this poor horse, I just have to ask --

I anyone old enough (or enough of a fan) to remember the Abbott & Costello routine in which Lou "proves" (in several ways) that 7x13=21 ? That's how I felt reading the arguments that plan loan interest is "double-taxed".

[g8r]

Here's an expansion of the example that may help those who don't understand why it's tax neutral. If you think there is double taxation (at least the way everyone is using the term here) then I'll agree.

But, as used in that context, there is double taxation regardless of whether the loan is taken from the plan or not!! As pointed out, that's the reason taking the loan from the plan is tax neutral (assuming it's paid off). See the changes I made to part 2 -- And, look at the end result. That's where people are getting lost.

I want to buy a car for $10,000. I have two options:

1. I borrow $10,000 at 5% for five years from the plan.

Now my account has an investment earning 5% (which may not be bad these days).

Loan is repaid with after-tax dollars. Let's say the interest is $500.

The $500 is taxed "again" at retirement. (This is why some think there is double taxation).

2. I borrow $10,000 at 5% for five years from the bank.

Loan is repaid with after-tax dollars. Again, I paid $500 to the bank and I'll never see that money again.

But.... here's the reason why there is no tax advantage. What happens in my account? I didn't withdraw the $10,000 to get the loan so it stayed in the plan. And, assuming it earned 5%, I now have an extra $500 in my -- and that interest will be taxed when I withdraw it.

So, what's the end result at retirement?

I've paid $500 of interest with after-tax dollars (either to the plan or the bank)

I get a distribution of $500 in interest from the plan (and it's taxed regardless of whether the loan originated from the plan or a bank), and

I have a car worth $0.

[Guest pjb]

q8r, you might want to start another message string. I don't think anyone in this disagrees with you. However, I think the pro double-tax people view the loan as from the person's own assets, not the plan, not a bank. If you were silly enough to set up a loan with interest against your personal savings account, should the interest you put in be taxed again when you withdraw that interest? If it was taxed, I think you'd prefer to not pay any interest on this loan and accept the lost interest the account would have received had you not taken the loan.

[Brian Gallagher]

Here's an example (I think I posted it on another board, but here it is again). It's a bit silly, but not out of the real of possibility:

I borrow $10,000 from my 401(k) Plan.

I take the check, cash it at the bank and get 100 $100 bills.

I bring them home and spread them across the table. I just want to see what $10,000 in cash looks like. (I don't know about you guys, but I never had the opportunity to hold 10 large in my hands).

The next day, I deposit the money into my bank account.

The day after that I write a check back to the 401k plan for $10,000 (plus a little interest.

I haven't paid tax on anything other than the interest.

How can I be taxed twice then?

[four01kman]

Brian,

You were taxed on the income used to pay the small amount of interest; then when that small amount of interest is distributed from the plan, it is part of a taxable distribution. This is why some people talk about "double taxation".

I am in agreement with the main thrust of this thread which deals with the neutrality of the loan transaction. The income of the fund is going to be taxed no matter from where it comes; income on investments or interest on a plan loan.

[g8r]

Pjb, I'm not sure another thread would help. I think we've almost solved the mystery.

You raised a good point. When comparing a loan from the plan vs. a loan from a bank, it's tax neutral.

When comparing any loan (bank or plan) to using money from your own savings account and paying yourself "interest", you're always better off. The reason is because with a personal account, I can't pay myself interest -- it's a contribution. If I withdraw $10,000 and determine that I'm going to pay back $10,000 plus $500 of interest (that I would have otherwise paid to either the bank or the plan), the $500 is a contribution and isn't taxed when I withdraw it. If I were to leave the money in my savings account and borrow from the bank or plan, then if my savings account earns $500 (because I didn't withdraw funds from the account), I pay taxes because it's earnings. So, any true "loan" is at a disadvantage over using money from your own savings account. But, if you need a true "loan", then it's tax neutral whether you get if from a bank or the plan.

I think that sums it up (at least for me).