401(k) loans: Are you really taxed twice?
Following my recent post on 401(k) loans, a number of you asked for more detail on the rules around taxes on plan loans and repayments. So I thought I’d delve deeper into the topic of being (or not being) taxed twice.
Two things are important. First, it’s easy to see you aren’t “taxed twice” on the principal balance of a “k” loan. If you borrow $10,000 from your retirement plan, you receive $10,000 to use as you want—you don’t have to pay taxes on it. Putting that money back into your plan account doesn’t involve paying additional taxes. You’re just repaying money you borrowed. Yes, you’re using after-tax money to replace your pre-tax money. But you also used pre-tax money to, for example, buy a car, or pay off credit cards, so it all evens out. (Looking at it another way—if you want to think of the $10,000 you’re using to repay your loan as a discrete sum of money, you may argue that it gets taxed when you first receive it as income and again when you withdraw it in retirement. But the “other” $10,000—the money you withdraw as a loan—never gets taxed. Not when you first stick it in the 401(k), and not when you take it out and use it.)
Second, on the interest component, it’s more complicated. Here, the “interest” you’re paying on a retirement plan loan is new money you are putting into your account. You’re using after-tax dollars to make these interest payments/contributions, as opposed to the pre-tax dollars that you might normally put into the plan. When the money comes out in retirement, however, you owe income tax on this “interest” at the same rate as the other pre-tax amounts in the plan. So, in this sense, you “pay tax twice” on the interest.
While this seems to make intuitive sense—and might seem to represent an important cost of a 401(k) loan—there is a subtle issue here.
Suppose, just for a minute, that your entire 401(k) were entirely invested in bonds offered by your local bank (which is silly, and not a recommendation of any kind, but will help me make this point). If you had borrowed $10,000 from that bank instead of your retirement plan, you would pay the interest you owe on the loan out of your after-tax income. But the bank would turn around and take your interest (and that of its other creditors) and use it to pay interest it owes on its bonds—among other things—which you hold in your 401(k). That interest is what accrues in your account, and you will pay income taxes on it (again) when you draw it out in retirement.
This example highlights the fact that all interest you receive is, in this sense, “taxed twice.” Of course, the big difference is that in a 401(k)-style plan the “interest” is entirely your own money—not that of the bank’s creditors. So, while the “taxed twice” thing is absolutely true with respect to the interest, it’s not clear that it’s relevant at all to the loan decision. The other factors I mentioned in my previous post are what you should really focus on.
This example highlights the fact that all interest you receive originates from someone else’s after-tax income, and is in this sense ultimately “taxed twice.” Of course, the big difference is just that with a k-plan loan, the “interest” is entirely your own money, not that of the bank’s creditors. So while the “taxed-twice” thing is absolutely true with respect to the interest, it’s not clear that it’s relevant at all to the loan decision. (Though the very technically inclined might want to look at this paper from the Federal Reserve, which suggests that a cost could creep in, given particular differences in rates of return.)
The bottom line: In general, the other factors I mentioned in the original post are what you should really focus on.
Notes:
- Consider consulting a tax or financial advisor about your individual situation.
- The link to FederalReserve.gov will open a new browser window. Vanguard accepts no responsibility for content on third-party sites.
Show me the math.
My guess is it is a vey bad idea to take money from a 401k plan, if you worked for a large and well run company, untill you absolutely have to do it. matching funds and good returns are more likely when a financial exec. is running the show. Pensioners, for the most part, don’t allow for poor management of their finances.
The IRS makes people pay interest on 401ks and requires people to pay back loans using after tax dollars for one reason. The insurance industry lobbied to place these rules into effect. The insurance industry considered the 401k the single biggest negative impact to life insurance and annuities. When I first saw this years ago, I didn’t think much about it. Then my insurance agent said to me years later. Well you need to take out term or universal Life insurance depending on how big your 401k is. If you have a big 401k then take out term insurance.
There is not logical or financial reason to have loans repayed with after tax dollars. It is just the insurance industry trying to check the competition. One can alway find a so called logical, make sense reason if they try hard enough.
John,
I think the follow-up helped explain the original question concerning the double taxation myth better than originally. Why it might have been tough to do in a blog, showing the two scenarios — the myth of the double taxation as compared to the reality of the cost of borrowing — with real numbers could have helped those of us who become lost in the abstraction with a more detailed and concrete analysis.
Thanks again.
Just a thank you for the work you have put in! i will definately be back.
Here’s the math worked out. For simplicity, assume that you pay back your loan in a single payment; the math is still valid if you pay in back with regular monthly payments, with each payment computed separately.
You borrow $10,000 at 6% interest from your 401(k), and you are in a 25% tax bracket. One year later, you pay back $10,600 to the 401(k). In order to get that extra $600 to pay back the loan, you needed to earn $800 pre-tax, and you’ll get taxed again on the $600 when you withdraw it. This is what “double taxation” means.
Now consider the alternative, in which you leave the $10,000 in your 401(k) invested in bonds earning 6%, and take out an ordinary $10,000 loan from your bank at 6% interest. Unless the interest on the bank loan is tax-deductible (which it might be for a home equity loan), you will need to earn an extra $800 pre-tax to pay the back the $600 in interest. Thus, you will be in the same position if you can get the same interest rate on both loans and on the investments in your 401(k).
where do i go to make a loan from my 401k
Finally, I find someone who I believe has the correct answer. The way my simplistic brain figured it is as follows:
Day 1 – loan $10k from 401(k) & put under my mattress. Thus, I received $10k pre-tax & nobody taxed me to stick it under my mattress.
Day 30, I dig out the $10k 401(k) pre-tax $ from under my mattress & repay the principal on the 401(k) loan. Thus, the PRINCIPAL of the 401(k) loan has been repayed with pre-tax money. Problem is they say I also need to pay $X of interest so I do BUT I must use AFTER TAX $. The good news its goes into my 401(k) BUT the bad news is I get taxed again when I remove it.
Summary: The correct answer is repayment of the PRINCIPAL of a 401(k) loan is PRE-TAX $ while payment of the INTEREST is AFTER-TAX $ that will get TAXED AGAIN when its withdrawn.
Note that the $ used to repay the loan don’t care if they’ve been stuck under a mattress or turned into a new boat & substitute $ used to repay.
Hope this helps, it did for me. Let me know if I missed something.
Thx
If I give someone the money to repay the balance on their “401K”loan what are the pros and cons to this. Will they have to claim this money as income for tax purposes? Will I be helping or hendering them? I appreciate your knowledge and help in this decision?
Ok now – Last year I took a $15K loan from my 401K. I now have the money in savings to pay it back. Should I???
I want to take a loan from my 401K to start a business. Should I????
It’s wrong to break a fundemental rule such as double taxation. The interest on a 401K loan should be repaid with pre-tax dollars as it is part of my 401K which is supposed to be all tax free until I go to use it in retirement.
It’s just to bad goverment can’t stick to fundenmental ideas. Broke 2 fundementals with 1 policy?
Double taxation and 401K funds 100% not tax free until retirement.
No wonder we need big government to make up so many stupid rules so they can tax us more and devise ways to complicate simple things.
If you lose your job due to the economy, does that fall under the hardship rule. And if you draw it out under these terms, do you have to pay it back or just consider that a withdraw. And how will you be taxed?
There is talk on my employer’s website and other places about “double taxation” of 401K loans. This “double taxation” comment is just a strange thing to say.
For starters, I have $1,000 in my 401K.
Now, let’s say I get a $1,000 loan from a bank, I need to earn about $1,388 pre-tax to pay back my $1,000 loan ($1,388 * (1-28%) = $1,000. I still have the $1,000 in my 401K that I started with. I need to pay taxes on the $1,000 in my 401K when I retire.
Or, let’s say I get a $1,000 loan from my 401K, I need to earn about $1,388 pre-tax to pay back my $1,000 loan ($1,388 * (1-28%) = $1,000. I still have the $1,000 in my 401K that I started with. I need to pay taxes on the $1,000 in my 401K when I retire.
Or, let’s say I don’t get a loan and just stick the $1,388 in my 401K. Now, I have $2,388 in my 401K that I need to pay taxes on. I (of course) need to pay taxes on all $2,388.
In any case, I’m paying taxes on $2,388. I’m never paying double.
Paying myself interest even if it is taxed paying in and coming out. I’m only being taxed once on the money it earns. Paying the bank I don’t see the earnings.
Here is another scenario.
10k loan on 401k (this is the market value as of the day of loan (why didn’t anyone discuss this in this article).) take it and put it under mattress. Now the market value fluctuates, when paying back on day 30. the market value of the fund/bond bought could be different, there by chance of making or loosing money!. Let say like 08 Oct the market crashed, your 10k market value is only 6.5 k (average 35% decline). Since you took it before crash and investing after the crash, you essentially by 10k worth of bonds at a cheaper price (your gain is 35%). There by your net worth is increased when market goes back up.. any thoughts on this scenario?
wow, a bunch of people that think they know what the tax brackets are going to be in say 20 years, it’s all good and well to run the math over 12 months, but whether or not that’s an accurate description of what’s actually going to happen is certainly up for debate, most people taking 401k loans aren’t paying the balance back within 12 months…..dems da facts
can i borrow more money to pay existing loan to get more money