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Participant Plan Loan and taxation


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Is it correct that if a participant takes a plan loan from their pre-tax 401k deferral account that they are essentially double taxed when they make the payments back on an after tax basis.  Taxed once when the deferral is made and then taxed again when they take a distribution from the plan?

I'm trying to figure out how it would be a good idea to take a plan loan if the taxation on the money is detrimental to the employee?

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Be careful about a plan or employer official getting involved in personal matters of employees, especially in giving tax advice.  The specific requirements for plan disclosure about taxes, such as the rollover notice, are firmly established.  Don’t go beyond them.

I will let others address the substance of your question.  That horse has been beaten to death long ago, notwithstanding never-ending attempts to keep riding it.

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No, participants are not double taxed on loans. I'd be happy to prove it mathematically if you like.

Even though loan repayments are made with after-tax money, the loan withdrawal, unlike a plan distribution, is not taxed.

Free advice is worth what you paid for it. Do not rely on the information provided in this post for any purpose, including (but not limited to): tax planning, compliance with ERISA or the IRC, investing or other forms of fortune-telling, bird identification, relationship advice, or spiritual guidance.

Corey B. Zeller, MSEA, CPC, QPA, QKA
Preferred Pension Planning Corp.
corey@pppc.co

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It is absolutely NOT correct.  Do yourself a favor. On a piece of paper map out what would happen with a plan loan vs a bank loan and see how the participant ends up exactly the same in both cases.  No double taxation.

Lawrence C. Starr, FLMI, CLU, CEBS, CPC, ChFC, EA, ATA, QPFC
President
Qualified Plan Consultants, Inc.
46 Daggett Drive
West Springfield, MA 01089
413-736-2066
larrystarr@qpc-inc.com

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There is double taxation on the loan interest because it is paid with after-tax dollars and is considered investment earnings and taxable when distributed, but not on the loan principal. Usually the amount of interest is inconsequential, but as Larry said - do the math (including how your assets would do if remaining invested rather than borrowed) to see how you make out.

Kenneth M. Prell, CEBS, ERPA

Vice President, BPAS Actuarial & Pension Services

kprell@bpas.com

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18 hours ago, Larry Starr said:

It is absolutely NOT correct.  Do yourself a favor. On a piece of paper map out what would happen with a plan loan vs a bank loan and see how the participant ends up exactly the same in both cases.  No double taxation.

Strictly speaking they aren't exactly the same position as a bank loan.  In a bank loan the bank got the interest and paid taxes on those earnings.  With a 401(k) loan your retirement plan got the interest the person paid and will pay taxes on those earnings when paid from the plan.  But unless the tax rate is over 100% they actually are better off paying the interest to themselves over the bank. 

The above leaves aside the opportunity cost of what the money could have earned if left in the 401(k) plan.  But if a person maps out the flow of money a bank loan means the bank gets 100% of the interest and pays taxes.  In a 401(k) loan the person gets 100% of the interest and will some day pay taxes on the interest. 

 

In the end I basically agree with Larry and the difference here can be small. 

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Not even the interest is double taxed.

Let's say on 12/31/2019 your account balance is $50,000. During 2020 your account experiences a rate of return of 5% and there are no contributions. Your balance on 12/31/2020 is $52,500 and you immediately take a distribution. Your taxable salary for 2020 is $100,000 so your total taxable income for 2020 is $152,500.

Now let's say you take a loan on 12/31/2019 for $10,000 at 5% interest, payable as single installment in 1 year (ignoring the quarterly requirement for simplicity). On 12/31/2020 your account is $42,000, plus you make your single loan repayment of $10,500, then take your distribution of $52,500. Once again your taxable income for 2020 is $152,500 - exactly the same as without the loan.

If the interest portion of the loan repayment were pre-tax, then the taxable salary would have been only $99,500 and the total taxable income would be only $152,000 - less than without the loan.

Free advice is worth what you paid for it. Do not rely on the information provided in this post for any purpose, including (but not limited to): tax planning, compliance with ERISA or the IRC, investing or other forms of fortune-telling, bird identification, relationship advice, or spiritual guidance.

Corey B. Zeller, MSEA, CPC, QPA, QKA
Preferred Pension Planning Corp.
corey@pppc.co

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2 hours ago, CuseFan said:

There is double taxation on the loan interest because it is paid with after-tax dollars and is considered investment earnings and taxable when distributed, but not on the loan principal. Usually the amount of interest is inconsequential, but as Larry said - do the math (including how your assets would do if remaining invested rather than borrowed) to see how you make out.

ESOP Guy and CuseFan are both wrong; THERE IS NO DOUBLE TAXATION; that is to say, there is NO difference between a bank loan and a plan loan from the standpoint of the participant and his taxation.  They are NOT inherently better off paying the interest to themselves (actually, never themselves; to the plan) than the bank.

Borrow from the bank; pay back your loan and interest (assume interest is not deductible).

Borrow from the plan, pay back your loan and interest (assume interest is not deductible).

So far, the same. 

In the plan, look at two scenarios: 1) No loan ever taken.  When he is paid out, he pays taxes on his account.

2) Loan taken. When he is paid out, he pays taxes on his account.

No difference. No double taxation.  The funds that he borrowed would have earned a rate of return in the plan if it had not been removed and placed with a "note receivable", which is still a plan investment just like any stock or bond.  If the earnings on the note receivable exactly equal the earnings that would have been earned on the stocks/bonds that were replaced, then his account is exactly the same when distributed and the taxation is identical.  The difference has to do ONLY with the earnings on the account and the earnings on the loan.  And if the account did better than the loan (this year, the S&P 500 index is over 21% as of today; a loan is probably 6 - 7%), then having the loan produces a NET LOSS to the participant in his retirement benefits. The other possible difference is the loan rate between the plan and the bank, but no matter what it is, THERE IS NO DOUBLE TAXATION.

The recurring error of so many people on their understanding of how this works mystifies me.  It reminds me of the Monte Hall problem (Google it if you don't know what I'm talking about).  The only answer that is correct is ALWAYS take the deal. It raises you odds from 1/3 to 1/2!

 

Lawrence C. Starr, FLMI, CLU, CEBS, CPC, ChFC, EA, ATA, QPFC
President
Qualified Plan Consultants, Inc.
46 Daggett Drive
West Springfield, MA 01089
413-736-2066
larrystarr@qpc-inc.com

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30 minutes ago, C. B. Zeller said:

Not even the interest is double taxed.

Let's say on 12/31/2019 your account balance is $50,000. During 2020 your account experiences a rate of return of 5% and there are no contributions. Your balance on 12/31/2020 is $52,500 and you immediately take a distribution. Your taxable salary for 2020 is $100,000 so your total taxable income for 2020 is $152,500.

Now let's say you take a loan on 12/31/2019 for $10,000 at 5% interest, payable as single installment in 1 year (ignoring the quarterly requirement for simplicity). On 12/31/2020 your account is $42,000, plus you make your single loan repayment of $10,500, then take your distribution of $52,500. Once again your taxable income for 2020 is $152,500 - exactly the same as without the loan.

If the interest portion of the loan repayment were pre-tax, then the taxable salary would have been only $99,500 and the total taxable income would be only $152,000 - less than without the loan.

Give that man a cigar!  AMEN!

Lawrence C. Starr, FLMI, CLU, CEBS, CPC, ChFC, EA, ATA, QPFC
President
Qualified Plan Consultants, Inc.
46 Daggett Drive
West Springfield, MA 01089
413-736-2066
larrystarr@qpc-inc.com

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47 minutes ago, C. B. Zeller said:

Not even the interest is double taxed.

Let's say on 12/31/2019 your account balance is $50,000. During 2020 your account experiences a rate of return of 5% and there are no contributions. Your balance on 12/31/2020 is $52,500 and you immediately take a distribution. Your taxable salary for 2020 is $100,000 so your total taxable income for 2020 is $152,500.

Now let's say you take a loan on 12/31/2019 for $10,000 at 5% interest, payable as single installment in 1 year (ignoring the quarterly requirement for simplicity). On 12/31/2020 your account is $42,000, plus you make your single loan repayment of $10,500, then take your distribution of $52,500. Once again your taxable income for 2020 is $152,500 - exactly the same as without the loan.

If the interest portion of the loan repayment were pre-tax, then the taxable salary would have been only $99,500 and the total taxable income would be only $152,000 - less than without the loan.

How does the arithmetic work if there is (nearly) zero gain in the account.  For instance if the money was invested in the money market.

Scenario 1:  Account balance $50,000, salary $100,000.  Income $150,000.

Scenario 2:  Account balance $40,000, loan payment $10,500, salary $100,000.  Income $150,500.

 

I look at it this way:  say I always wanted to see what $20,000 in cash looks like?  Where can I get my hands on some cash?  My 401(k) Plan!  I'm conservative, so I've kept everthing in cash.

I have $40,000 in there I haven't paid taxes on, so I take a $20,000 loan.  I get the amount wired to my bank account and then proceed to get 20,000 singles in cash from the teller.  Then I go home, dump it all on the bed and roll around naked in all that cash!  $20 grand, tax free!  whoo hoo!

Then the next day, I stack it neatly up and I'm ready to bring it back to the bank and put it into my account.  Still not taxed.  Now I'm gonna pay it pack.  Lets say there's $100 of interest due by time I pay it back to my account.  So, I reach into the coffee can and pull out a $100 bill that I've PAID TAX ON ALREADY, and put it into my account, along with the original 20 large.

Next day I write a check for $20,100 which goes into my account in a couple days.

Then I get fired.  (I skipped work the day I was rolling in the dough, so to speak).  So I want to take a distribuiton.  I take it all in cash.  My 1099-R is going to say $40,100.  I will be taxed on my $40,000 basis, plus on the hundred bucks I've already paid tax on.

QKA, QPA, CPC, ERPA

Two wrongs don't make a right, but three rights make a left.

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47 minutes ago, BG5150 said:

How does the arithmetic work if there is (nearly) zero gain in the account.  For instance if the money was invested in the money market.

Your taxes will be higher with the loan, but solely because you invested a portion of your account in an investment with a higher rate of return which resulted in your having a larger benefit at the end of the year - not because of anything intrinsic to the nature of the investment as a loan.

Free advice is worth what you paid for it. Do not rely on the information provided in this post for any purpose, including (but not limited to): tax planning, compliance with ERISA or the IRC, investing or other forms of fortune-telling, bird identification, relationship advice, or spiritual guidance.

Corey B. Zeller, MSEA, CPC, QPA, QKA
Preferred Pension Planning Corp.
corey@pppc.co

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Thanks Larry - I worked out the math on it using actuarial notation a while back, just to prove it to myself. I found it to be a very useful exercise.

Free advice is worth what you paid for it. Do not rely on the information provided in this post for any purpose, including (but not limited to): tax planning, compliance with ERISA or the IRC, investing or other forms of fortune-telling, bird identification, relationship advice, or spiritual guidance.

Corey B. Zeller, MSEA, CPC, QPA, QKA
Preferred Pension Planning Corp.
corey@pppc.co

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12 minutes ago, C. B. Zeller said:

Thanks Larry - I worked out the math on it using actuarial notation a while back, just to prove it to myself. I found it to be a very useful exercise.

Another keyboard lost.

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4 hours ago, C. B. Zeller said:

Your taxes will be higher with the loan, but solely because you invested a portion of your account in an investment with a higher rate of return which resulted in your having a larger benefit at the end of the year - not because of anything intrinsic to the nature of the investment as a loan.

But the gain on that investment came from dollars provided by me.  I took them out of my pocket, parked in the 401(k) plan for a short time and then was taxed on that amount on the way out.

QKA, QPA, CPC, ERPA

Two wrongs don't make a right, but three rights make a left.

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Simple example 1:

I get paid $10,000 day 1 and put all of it in my 401(k).  My taxable income is $0.  I have $10,000 in my 401(k) plan and $0 in the bank.

On day 2, I get paid $10,000 and I put it in my bank account.   My taxable income is $10,000. Note I have been paid $20,000 in wages.  I now have $10,000 in my 401(k) plan and $10,000 in the bank. 

On day 3, I take a 401(k) loan of $10,000 (ignore the rules on how much I can take it doesn't matter for this problem).  My taxable income is $10,000.  I now have $10,000 (note) in my 401(k) plan and $20,000 in my bank account. 

On day 4, I pay back $10,100 to the 401(k) plan to repay my loan.  My taxable income is $10,000.  I now have $10,100 in my 401(k) plan and $9,900 in my bank account. 

On day 5, I take a full distribution from my 401(k) plan which is $10,100.  My taxable income is now $20,100. I now have $0 in my 401(k) plan and $20,000 in my bank account.

Those people who say I am not taxed on the interest how can my wages be $20,000 and my taxable income be $20,100 if the interest isn't double taxed at some place along the line?  How did I get $20,100 in taxable income and only $20,000 in my bank account? 

 

Simple example 2: 

I make $10,000 on day one and put it in my bank account.  My taxable income is $10,000 and I have $10,000 in my bank account.  

On day 2, I get paid $10,000 and I put that in my bank account.  My taxable income is $20,000 and I have $20,000 in my bank account. 

On day 3, I take out a $10,000 loan from my bank and put it in my bank account.  I now have taxable income of $20,000 and I have $30,000 in my bank account. 

On day 4, I pay back the bank loan for $10,100.   My taxable income is $20,000 and my bank account has $19,900 in it. You will note my taxable income is lower here but my bank account is $100 higher than in example 1.  So unless the taxes on the double taxed interest is 100% or higher you are better off paying the interest to yourself ignoring opportunity costs. 

Until someone can explain where they think I got the math or law wrong I stand by my claim that interest is double taxed and you are better off paying the interest to yourself than the bank.  Once again on that last part I am ignoring (as admitted the first time) the opportunity cost of taking the funds out of the 401(k) plan and them not being invested in the market. 

 

But I took Larry's challenge and ran the numbers and they support my claims.  

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2 hours ago, BG5150 said:

How does the arithmetic work if there is (nearly) zero gain in the account.  For instance if the money was invested in the money market.  SO WHAT. The rate of return is immaterial (please, TRUST ME) to the issue.

Scenario 1:  Account balance $50,000, salary $100,000.  Income $150,000.

Scenario 2:  Account balance $40,000, loan payment $10,500, salary $100,000.  Income $150,500.

The two scenarios are not the same, so you start out comparing two non-comparable situations.  

I look at it this way:  say I always wanted to see what $20,000 in cash looks like?  Where can I get my hands on some cash?  My 401(k) Plan!  I'm conservative, so I've kept everything in cash.

Fine.

I have $40,000 in there I haven't paid taxes on, so I take a $20,000 loan.  

And you STILL have $40,000 there.  All that is happened is you replace one investment (in the money market, in this case, but who cares?) with another one (a "note receivable" as indicated by the loan distribution.

I get the amount wired to my bank account and then proceed to get 20,000 singles in cash from the teller.  Then I go home, dump it all on the bed and roll around naked in all that cash!  $20 grand, tax free!  whoo hoo!

Again, who cares.  You can set fire to it or buy an ice cream truck or $20k in ice cream. It just doesn't have anything to do with the issue.

 

2 hours ago, BG5150 said:

Then the next day, I stack it neatly up and I'm ready to bring it back to the bank and put it into my account.  Still not taxed.  Now I'm gonna pay it pack.  Lets say there's $100 of interest due by time I pay it back to my account.  So, I reach into the coffee can and pull out a $100 bill that I've PAID TAX ON ALREADY, and put it into my account, along with the original 20 large.

It just doesn't matter that you paid tax on that $100.  You are using it to repay the plan for the earnings it did not get on the stocks it should have owned because they replaced it with your loan receivable.

Next day I write a check for $20,100 which goes into my account in a couple days.

Then I get fired.  (I skipped work the day I was rolling in the dough, so to speak).  So I want to take a distribuiton.  I take it all in cash.  My 1099-R is going to say $40,100.

And it would have said the same $40,100 if, instead, you had not taken the loan and the plan earned $100 in that time on the "unloaned" money.  

 I will be taxed on my $40,000 basis, plus on the hundred bucks I've already paid tax on.

WRONG WRONG WRONG.  You don't have a basis in that account. You have a retirement account of $40,100, with or without having taken the loan.  All of which is taxable if you take it.

 

36 minutes ago, BG5150 said:

But the gain on that investment came from dollars provided my me.  I took them out of my pocket, parked in the 401(k) plan for a short time and then was taxed on that amount on the way out.

The gain on the investment (the increase of $100) came from the return on the investment of plan assets (whether a  loan receivable or a mutual fund return).  It's money that came from the return on the investment the plan made in a loan; it did not come FROM YOU.  And that is your problem.  You can't seem to get past that, so with the above, I am done and just hoping you see the light.  Or, that you can accept you just don't get it, that you are wrong, that you don't understand why you are wrong, but you accept it with the hope that some day the light bulb will actually go off and you say "OH, THAT'S WHAT THEY WERE SAYING".  I'm going to guess you don't understand the math of mulidimensional universes and probably won't understand it no matter how many times I try to understand it.  But you might accept that you don't understand it, and that those who do are accurately explaining it.  "One notable feature of string theories is that these theories require extra dimensions of spacetime for their mathematical consistency. In bosonic string theory, spacetime is 26-dimensional, while in superstring theory it is 10-dimensional, and in M-theory it is 11-dimensional".  Doesn't make any sense to you (or me for that matter) but it is true.  I accept that.  Can you accept the truth that interest on loans from plans are not double taxed? Probably not, huh? ?

You are SO CONFUSED.  I don't know that I can get you to see what is true.  You are confusing many different things. You are comparing apples to succotash. I'm going to try to respond within your posting, but I am not hopeful the light bulb will go off in your head as to why you are wrong.

Lawrence C. Starr, FLMI, CLU, CEBS, CPC, ChFC, EA, ATA, QPFC
President
Qualified Plan Consultants, Inc.
46 Daggett Drive
West Springfield, MA 01089
413-736-2066
larrystarr@qpc-inc.com

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3 hours ago, ESOP Guy said:

Simple example 1:

I get paid $10,000 day 1 and put all of it in my 401(k).  My taxable income is $0.  I have $10,000 in my 401(k) plan and $0 in the bank.

On day 2 I get paid $10,000 and I put it in my bank account.   My taxable income is $10,000. You mean your cumulative taxable income is $10k because you have been paid $20k and you deferred $10k. Note I have been paid $20,000 in wages.  I now have $10,000 in my 401(k) plan and $10,000 in the bank. 

On day 3 I take a 401(k) loan of $10,000 (ignore the rules on how much I can take it doesn't matter for this problem).  My taxable income is $10,000.  For the same reason; nothing has changed.  You have been paid $20k cumulatively and deferred $10k cumulatively. I know have $10,000 (note) in my 401(k) plan and $20,000 in my bank account. 

On day 4 I pay back $10,100 to the 401(k) plan to repay my loan.  My taxable income is $10,000.  I now have $10,100 in my 401(k) plan and $9,900 in my bank account. It doesn't matter what you have in your bank account. Not at all.  Assume you bought a car with the loan so you have no money in that account.  But won the lottery today and got $10k winnings and used that to pay back the plan. The $100 is the amount THE PLAN earned on its investment in a loan receivable.

On day 5 I take a full distribution from my 401(k) plan which is $10,100.  My taxable income is now $20,100. Yes, the $100 extra is earnings of the plan (plus you have effectively dropped your deferral to zero so your two paychecks of $20k are now taxable) now have $0 in my 401(k) plan and $20,000 in my bank account.  It doesn't matter what is in your bank account.  You were paid $20k from you employer; TAXABLE.  You netted $100 from the temporary deferral into the 401(k) plan, so you have $20.1k of taxable income this year.

Those people who say I am not taxed on the interest how can my wages be $20,000 and my taxable income be $20,100 Which is actually a taxable W-2 of $10k  and a distribution from  your retirement plan of $10,100 on a 1099R if the interest isn't double taxed at some place along the line?  That conclusion is a complete non sequitur. It does not follow at all from the previous itemsHow did I get $20,100 in taxable income and only $20,000 in my bank account? Because you were paid $20k in total income from your employer (of which $10k went in and out of the plan) plus an additional $100 from the plan. That's how you got it. That has NOTHING to do with double taxation; NOTHING.

 

Simple example 2: 

I make $10,000 on day one and put it in my bank account.  My taxable income is $10,000 and I have $10,000 in my bank account.  

On day 2 I get paid $10,000 and I put that in my bank account.  My taxable income is $20,000 and I have $20,000 in my bank account. 

On day 3 I take out a $10,000 loan from my bank and put it in my bank account.  I now have taxable income of $20,000 and I have $30,000 in my bank account. Who cares what you have in your bank account; that is what is screwing you up.  You have $20k in taxable income and you have a $10k loan which is completely offset at this point by $10k in cash which you haven't spent.  Go buy a used car for $10k.  Your net worth hasn't changed one iota (assuming car value has not changed); you have just swapped cash for car.

On day 4 I pay back the bank loan for $10,100.   My taxable income is $20,000 and my bank account has $19,900 in it. Because you paid $100 for the cost of borrowing $10k overnight.  You will note my taxable income is lower here but my bank account is $100 higher than in example 1. Your taxable income is less in this example because you sat on your ass with the $10k instead of investing it overnight to earn $100!!!! It is no longer the same example.  The plan INVESTED that $10k (loan or stocks) and it happened to earn $100 on that investment. So unless the taxes on the double taxed interest is 100% or higher you are better off paying the interest to yourself ignoring opportunity costs. NONSENSE.  This is not a logical result of all the preceding. You keep making this statement and it is just plain wrong.  Now, there is absolutely no doubt that I am absolutely correct and you are absolutely wrong.  It is like Steven Hawking explaining black holes and you telling him you disagree with him!

Until someone can explain where they think I got the math or law wrong I stand by my claim that interest is double taxed and you are better off paying the interest to yourself than the bank.  I hope you see it now, but probably not, huh? Once again on that last part I am ignoring (as admitted the first time) the opportunity cost of taking the funds out of the 401(k) plan and them not being invested in the market. You can't ignore that. You are wondering why there is a $100 difference? That's because the plan DID invest your loan (it is called a note receivable) and it earned $100 on it.  If you ignore that, you get your example, plus you have to add $100!!!!!  What you did with it (go buy a used car) is immaterial!  It does not have to be invested OUTSIDE OF THE PLAN in the market and most loans won't be (they are used to pay off credit cards or medical bills or something like that). Any help?  Do you buy it?  But I am done trying to explain why we are right and you are wrong; just accept it if you don't see the math still.

But I took Larry's challenge and ran the numbers and they support my claims.  Of course they don't; only in your tortured example of the facts (your alternate universe! ? )does that work.

 

Lawrence C. Starr, FLMI, CLU, CEBS, CPC, ChFC, EA, ATA, QPFC
President
Qualified Plan Consultants, Inc.
46 Daggett Drive
West Springfield, MA 01089
413-736-2066
larrystarr@qpc-inc.com

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4 hours ago, Larry Starr said:

ESOP Guy and CuseFan are both wrong; THERE IS NO DOUBLE TAXATION; that is to say, there is NO difference between a bank loan and a plan loan from the standpoint of the participant and his taxation.  They are NOT inherently better off paying the interest to themselves (actually, never themselves; to the plan) than the bank.

Borrow from the bank; pay back your loan and interest (assume interest is not deductible).

Borrow from the plan, pay back your loan and interest (assume interest is not deductible).

So far, the same. 

Right, sort of.  If the participant had the opportunity to deduct interest paid on the loan, then taking a loan from a bank might be comparatively advantageous, assuming all the other loan terms are the same.   Interest deductions are pretty limited these days, but if the loan is for capital improvements to the home and a participant can borrow from a HELOC, it could be deductible if total home debt within the overall limit on home loans for deductibility. 

I say 'sort of' because saying "there is NO difference between a bank loan and a plan loan" is not the same thing as saying 'THERE IS NO DOUBLE TAXATION'.

I carry stuff uphill for others who get all the glory.

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13 hours ago, Larry Starr said:

 

So many words and yet you never explained why the person's taxable income is $20,100 when they had $20,000 in wages except they generated $100 in taxable income by paying the $100 interest on the 401(k) loan.

 

Likewise, you keep saying they are no worse off if they take a bank loan but as the math shows their bank account is $100 smaller if they take out a bank loan.  

 

The math is simple. 

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15 hours ago, ESOP Guy said:

Once again on that last part I am ignoring (as admitted the first time) the opportunity cost of taking the funds out of the 401(k) plan and them not being invested in the market. 

This is the key - your tax burden is higher solely because your account balance is higher. If you had invested that income and earned $100 in the market you would owe capital gains tax on it. Since plan earnings are taxed as normal income, not as capital gains, it is taxed as income when withdrawn from the plan.

Free advice is worth what you paid for it. Do not rely on the information provided in this post for any purpose, including (but not limited to): tax planning, compliance with ERISA or the IRC, investing or other forms of fortune-telling, bird identification, relationship advice, or spiritual guidance.

Corey B. Zeller, MSEA, CPC, QPA, QKA
Preferred Pension Planning Corp.
corey@pppc.co

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17 hours ago, Mike Preston said:

Another keyboard lost.

I promise no keyboards were harmed in my mathematical excursions!

Free advice is worth what you paid for it. Do not rely on the information provided in this post for any purpose, including (but not limited to): tax planning, compliance with ERISA or the IRC, investing or other forms of fortune-telling, bird identification, relationship advice, or spiritual guidance.

Corey B. Zeller, MSEA, CPC, QPA, QKA
Preferred Pension Planning Corp.
corey@pppc.co

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On 11/5/2019 at 6:32 PM, shERPA said:

Right, sort of.  If the participant had the opportunity to deduct interest paid on the loan, then taking a loan from a bank might be comparatively advantageous, assuming all the other loan terms are the same.   Interest deductions are pretty limited these days, but if the loan is for capital improvements to the home and a participant can borrow from a HELOC, it could be deductible if total home debt within the overall limit on home loans for deductibility. 

I say 'sort of' because saying "there is NO difference between a bank loan and a plan loan" is not the same thing as saying 'THERE IS NO DOUBLE TAXATION'.

Agreed. In the "old days", I always said a home equity loan is a better deal because you can deduct the interest.  In the new tax law environment, I have decided not to get into that discussion because of all the caveats that I would have to note, and I'm talking to the business owner who is going to pass this along to the participant, so I'm not going to try to get the nuances of interest deduction across as well.

Lawrence C. Starr, FLMI, CLU, CEBS, CPC, ChFC, EA, ATA, QPFC
President
Qualified Plan Consultants, Inc.
46 Daggett Drive
West Springfield, MA 01089
413-736-2066
larrystarr@qpc-inc.com

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11 hours ago, ESOP Guy said:

So many words and yet you never explained why the person's taxable income is $20,100 when they had $20,000 in wages except they generated $100 in taxable income by paying the $100 interest on the 401(k) loan.

 

Likewise, you keep saying they are no worse off if they take a bank loan but as the math shows their bank account is $100 smaller if they take out a bank loan.  

 

The math is simple. 

You  just don't get it. There is no chance you are right; there is a 100% chance you are wrong and those of us who understand it know that to be the truth.  However, I'm never going to get you to understand string theory, or plan loan math, so I'll respectively give up.  I absolutely did explain why the person's taxable income is $20,100 (they were paid $20k in W-2 and their retirement plan investment earned $100 which was also paid to them; is that really so hard to grasp?).  You continue to compare apples and oranges; work through my examples with an open mind; maybe the light bulb will go off, but probably not.

Lawrence C. Starr, FLMI, CLU, CEBS, CPC, ChFC, EA, ATA, QPFC
President
Qualified Plan Consultants, Inc.
46 Daggett Drive
West Springfield, MA 01089
413-736-2066
larrystarr@qpc-inc.com

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5 hours ago, Larry Starr said:

Agreed. In the "old days", I always said a home equity loan is a better deal because you can deduct the interest.  In the new tax law environment, I have decided not to get into that discussion because of all the caveats that I would have to note, and I'm talking to the business owner who is going to pass this along to the participant, so I'm not going to try to get the nuances of interest deduction across as well.

Yes I agree the limitations and complications are such that I’m not going to go into it at this level either. 

I carry stuff uphill for others who get all the glory.

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Here it is, once and for all.  I will save this response and use it the next time the issue arises.  It is much the same answer I have provided every time I have been asked, over the past 30+ years.  

All monies in an individual account retirement savings plan are tracked at least two ways – based on the source and based on the investment. 

A plan loan is an investment in yourself.  A plan loan does not change the tax status of the principal.  However, a plan loan does change the investment – those monies may have been invested in equities, fixed income investments, etc., but it becomes a fixed-income investment in yourself.  

There are loans structures out there where the loan is treated as another security within a fund (a bond fund, a money market fund, etc.)  That is, the loan transaction is a transfer to a specific plan investment, and then monies are borrowed from that investment and the loan note is just another investment in that fund.  You might see something like this in a 403(b) plan (where the loan may be made by the insurance company) or in a defined benefit pension plan.  In those situations, the loan interest you pay is treated the same interest paid on other securities held in the fund.     

However, in a 401(k) plan, almost always, the interest you pay is credited to your own account.  The source and tax status of the loan principal doesn’t change – so if the money was contributed as pre-tax 401(k) contributions, Roth 401(k) contributions, after-tax 401(a) contributions or employer 401(a) contributions, when the principal is distributed to you as a loan, there is no tax effect and when the principal is repaid to your account, there is no tax effect.  The money comes out and goes back in credited to the same source bucket.  The investment allocation is typically not the same when reinvested.  

All loan interest, whether paid on a commercial loan or on a plan loan is always paid with after-tax dollars.  The remaining questions are: 
•    Is there a tax deduction on the interest paid, and 
•    Is the interest taxable when received.  

There is a tax deduction on the interest you pay where the loan is secured with a qualifying mortgage and otherwise meets tax code requirements – whether the loan was sourced from a tax qualified plan or a commercial source.  

The interest received is taxable on the same basis as would apply to interest on any other fixed income investment in the plan.   So, whether the interest is paid based on an investment in bonds or paid by you on a loan, it is taxable income, with one exception.  

The exception is if the principal is Roth 401(k) contributions where the Roth monies remain in the plan to meet the 5 year age 59 ½ requirements.  The interest will be credited as Roth 401(k) interest.  And, if the participant meets the 5 year / age 59 1/2 requirement, it will come out of the plan ax free - the same as it would if it were interest on a bond investment.  

So, yes, you can pay interest on your plan and take a tax deduction where the interest you ultimately receive is not taxable income.  

Finally, yes, you did pay interest with after tax dollars that did not qualify for a tax deduction (except where properly secured with a mortgage)  and yes, you did have to pay taxes on interest you received from the plan (unless it is Roth 401(k) interest that qualifies for tax free treatment).  However, if you had borrowed from a commercial source, you would not receive the interest paid on the loan.  


That is, except for the exceptions detailed immediately above, there is no option to make loan interest payments with pre-tax contributions, and there is no option to receive interest from the plan tax free.  


Simply, these are two different amounts.  
 

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