401(k) loans

[Guest rfopiano]

I have a client whose company (Security Link) is being acquired by Tyco. He borrowed money from his 401(k) under old employer to purchase a home. Now he is being told that the loan either must be repaid, or treated as income, with penalties. Is there any relief for this situation? As a result of the acquisition, he is being transferred and must sell old residence and purchase a new one. What are his options? Thanks

[Jon Chambers]

I'd find out why the loan is being accelerated. I'd guess that the plan is being terminated as a result of the acquisition. In this case, his options are to pay off the loan, pay the taxes, or lobby someone to maintain the plan until he can pay off the loan. It's also possible, although highly unlikely, that he could be permitted to roll over the loan to the acquiring company's plan.

Here's yet another example of why 401(k) plan loans are not the great deal that they appear to be. I actively discourage participants from taking loans due to double taxation, no deductibility of payments, loss of earnings on borrowed amount, and the potential for unexpected acceleration due to layoff, merger, etc. But plan loans remain very popular.

[Guest deathbycashcall]

Sounds like the new plan does not provide for participant loans and that's why they can't allow its rollover. Another very good reason to convince employers not to put loans in their plans! As much as I detest plan loans.....note my name "death by cash call", I have never agreed that double taxation is an issue with participant loans. The money is not taxed when it is borrowed. Granted, the payments come from after-tax money but so would any other payments made on non-plan loans. You can simply pay yourself the interest or pay the bank. Unless your bank loan is secured by your home, the interest is probably not deductible either. And, although you receive the interest, it is not taxed to you because it's inside the tax-exempt plan. Loans certainly made a lot less sense when the market was climbing, but these days the loans are the only investments earning positive returns! To look at it another way....if loans repayments were allowed to be made from pre-tax money, we all would be taking loans!

[Jon Chambers]

Double taxation occurs because the loan repayments come back to you (eventually) as a plan distribution, and they are taxed at that point. You never received any basis for your after-tax loan payments, so you paid twice. Granted, you received the loan as a non-taxable event. It's a greater issue on interest payments than on principal payments, if you compare a plan loan to an alternate financing source (e.g., a home equity loan). With a home equity loan, your payments don't come back to you, but at least you get a deduction for the interest you paid.

Loans aren't necessarily the only investments earning positive returns. Most value stock funds are up more than 10% so far this year, real estate funds continue to do well and emerging markets are at least breaking even. Small cap stock funds are also generally up double digits so far this year, with the Russell 2000 up about 7% for the first 6 months. Bond funds have been doing extremely well for the past 18 months. Sure, tech stocks are down, but they are a relatively small segment of the market. More than 300 of the S&P 500 stocks were up in 2000; more than 250 were up more than 10%. Across the broad stock market, returns are much better than they were in 1998, when a few large cap growth stocks did very well, but most stocks were down. In my experience, well-diversified plan participants aren't experiencing losses, although gains aren't as large as they were a few years ago.

[Guest deathbycashcall]

Thanks, Jon, for your encouraging and informative comments about the market. I don’t think I argued my point very well about the double taxation…that’s what I get for staying up too late! So I’d like to try again. This is a pet peeve of mine. Let me start with strictly the principal portion of the loan repayment. I think that folks are forgetting the fact that the same pre-tax dollars that were borrowed from the plan are being put back into the plan. It may APPEAR that after-tax dollars are going in the plan as loan payments, but that’s only because they are being deducted from new income to the participant, i.e. payroll checks. If you argue that after-tax monies are going into the plan, what about the loan proceeds that were received and never taxed…what happened to those dollars? For example, let’s assume a participant takes a loan and puts the proceeds in his drawer. Every pay day he takes a small piece of it and remits it to the plan trustees. This is the same thing as an after-tax payroll deduction. But it is NOT after-tax money. It is the same pre-tax money he borrowed!

Now the interest that he pays could be argued as well. Putting aside deductible interest and lost opportunity for market returns, let’s assume the following. A 40% tax bracket taxpayer takes an after-tax dollar (now $.60) and pays interest on his participant loan. Ultimately, he withdraws the $.60 and pays 40% tax again leaving him with $.24. While he may have paid tax twice on the same dollar, he has not only received tax deferral of the income earned on the $.60 while in the plan, but he has $.24 left. Alternatively, he could have taken the same $.60 and paid interest to a bank, but he would have $.00 at retirement and no earnings on the $.60.

Finally, imagine if the IRS allowed loan repayments to be made via pre-tax payroll reductions. What a bargain that would be! We could put a dollar in the plan on a pre-tax basis, borrow it tax-free (keep it in the drawer) and get yet another tax deduction for paying it back from new income monies. This is why the payments are made from after-tax payroll deductions….it isn’t to create double taxation for the participant….just to avoid double income tax deductions for the same money!

If I haven’t convinced anyone, please respond via private message or post a message. I don’t have a lot of initials after my name, but I hear this “double taxation” issue quite frequently (and by some smart folks, too) and I just don’t think it’s right. I'm not saying loans are a good thing...I could argue many reasons why you shouldn't borrow from your plan...I just don't think this is one of the reasons. Or perhaps I just don’t get it and should spend less time in front of this computer and more time considering retirement!

[Jon Chambers]

And thank you for your cogent and well-considered commentary on double taxation. In general, I agree with you, at least as far as the principal payments, and your analogy of keeping loan proceeds in a drawer. I use a similar analogy--take a loan and immediately pay it back using the loan proceeds to pay off the loan. No double taxation. But I'm not sure I completely agree with your assumptions regarding loan interest. This is taxed twice. If the participant had not taken the loan from the plan, but had come up with a different financing source, he or she would (presumably) have earned more on their 401(k) plan account. Furthermore, if the alternate financing was in the form of a home equity loan, interest payments would be deductible. Let's assume that interest rates are equal for plan loans, home equity loans and the investments in the plan. I know this is unrealistic, but it keeps the comparison simple. In each case, repayment of principal, to the plan or to the bank, has no impact on wealth. You borrow money and pay it back. If you borrow from the plan, you earn less on your plan, but don't pay this interest to the bank. If you borrow from the bank, your interest payments to the bank are equal to the interest you earn on the amount you didn't borrow from the plan.

Now let's consider the taxation on the interest payments. The plan loan interest is paid with after tax dollars, and is taxed again when it comes back to you. Double taxation. The bank loan interest is deductible, and doesn't come back to you. No taxation. One more thing to consider, however--you do earn more in the plan when you borrow from the bank, and these earnings eventually come back to you, so you implicitly face single taxation in the bank loan scenario.

This is my take on double taxation. I think it's a valid observation, provided you understand it applies to interest payments only, when you have a tax-advantaged alternative borrowing mechanism, such as a home equity loan. I concur that many people simply spout "double taxation" without thinking through what they mean. I'd be interested in your thoughts on my analysis--it's certainly possible that I'm missing something here.

[Guest deathbycashcall]

And thanks to you for your thoughtful reply! I think we're on the same page now. Participant loans are a bad thing. Interest is taxed twice. Home equity loans are a better alternative. Here's a novel idea....live within your means! I sure wish we were more successful in keeping loan provisions out of plans. Even if we convince an employer not to put a loan provision in their plan, they end up adding one when the first "cash call" whines loud and long enough. Next thing you know the cash call line gets longer and longer, the participants can't afford to continue to participate in salary deferrals because they're paying back their loan, the owner is cut back on what he can do and the plan dies a slow agonizing death....not to mention the fact that the folks who can least afford it are the ones that you and I will be supporting when we're retired! While I'm on my soapbox, let me say one more thing. While I think the politicians have done a very positive thing with EGTRRA, the real goal will never be accomplished until retirement distributions are strictly limited to death, disability and retirement. Period. Appreciate the good dialogue, Jon. We pencil-pushing number-crunchers appreciate the time you obviously spend on this website!

[stephen]

Jon and deathbycashcall,

How do you feel about taking a loan from the 401(k) plan to be used as a down payment on a house?

Thank you for the insight on the double taxation applying to the interest portion only!

[Jon Chambers]

I'd say it's acceptable, provided that you are reasonably certain that the loan won't be accelerated due to a job change, layoff or corporate acquisition. But if you have any reasonable alternative to borrowing from the plan, you may be well served to take it. For example, when my wife and I bought our house (we're both in the retirement plan industry) and we didn't have enough saved for a 20% down payment, we decided to take out a second mortgage to supplement our savings, instead of borrowing from our retirement plans. Although the interest rate was higher on the second, it is deductible, and we have subsequently refinanced. We have managed to avoid double taxation, and we've kept our retirement assets growing.

In summary, I'd say don't borrow from a loan shark instead of the plan, but if you have a reasonable alternative that provides for deductible interest, take it. If borrowing from the plan is the only way to get the house of your dreams, then borrow away and don't worry too much about the double taxation.