Loan default

[Guest 401kWorker]

No longer a 401k worker my Pension knowledge is rusty ! I have the option of defaulting on a 401k loan. If I pay the loan back, it is with after tax money that will be taxed again when I retire and withdraw? so doesn't it make sense to default and take the 10% penalty?

[pmacduff]

You never paid tax on the loan principal, only the interest payments you have made. People make the incorrect assumption that the loan payments are after tax, but the principal payments are not. Therefore, when the monies return to the plan as payments, you are only "replenishing" the principal which, as I mentioned, was never taxed to you to begin with. If you default now, you not only have the 10% penalty, you will pay the ordinary income tax rate....the theory of paying the loan back and taking the monies when you retire makes an assumption that you will probably be in a lower tax bracket at retirement, therefore your ordinary income taxes on that principal amount will be lower than they would now. You will also avoid the 10% tax at retirement (assuming it's after 59 1/2). Hope this helps.

[RCK]

If you let it default, you pay income tax, 10% penalty, and lose the potential tax deferral on future earnings.

If you repay it, you don't pay the income tax until later, you may be able to wait long enough to avoid the 10% and you have restored that tax deferral on earnings. But you do of course have to come up with the cash to do the repayment.

If I had the money to repay the loan, I'd do it.

In either case, I think that you have to change your username to "theworkerformerlyknownas401kworker".

[Guest 401kWorker]

401khelpcenter "Whether you repay the 401(k) loan out of your salary or from a bank account, those payments are all made back into the 401(k) with after-tax dollars. Then, when you retire and take withdrawals, you pay taxes yet again."

Chances are I will not be in a lower tax bracket at retirement.

If I take a deemed distribution, I only pay taxes once and a 10% penalty.

If I repay the loan, I pay taxes twice but avoid the 10% penalty. The earnings shelter loses relevance if I were to invest in an alternative tax shelter.

Thanks for the sarcasm !

[pmacduff]

I beg to differ on the portion of your sentence, "those payments are all made back into the 401(k) with after-tax dollars. Then, when you retire and take withdrawals, you pay taxes yet again."

I agree that is true with the interest, but when you take a 401(k) loan of deferrals or employer monies, you have not yet paid taxes on those funds. Perhaps an example will show it best...

you defer $5000 from your check. (no income taxes paid yet on those dollars, right?)

you borrow $2500 from your deferrals. Do you pay income tax on the $2500 when you take the loan?...NO!

You pay back $2500 plus interest. Even though it seems as though you are paying the $2500 back with after tax $, you have yet to pay any taxes on the original $2500 you are repaying the original tax deferred $.

I agree that the interest payments are made with after tax $. In a perfect world, we administrators could all track the interest payments on every loan from inception and when a distribution is ultimately made to the participant, you could separate the interest payments as after tax $ in the distribution. I don't believe that there are many out there who are actually reporting it this way. In any event, once you have paid back the $2500 to your account, it is back "intact" and you will not pay ordinary income taxes on it until it is distributed to you.

[MGB]

The 401khelpcenter is not very good help at all and is providing terribly inaccurate advice. You do not pay taxes twice.

Assume you took a loan for X dollars and you now have X dollars that you are trying to decide whether to pay back the loan. The argument put forward is that the X dollars you have now have already been taxed. That is not true. If you had not taken the loan, you would now have zero dollars (or whatever you have minus X). The X dollars you have now represent the X dollars that you took as a loan in a nontaxable transaction. It still has not been taxed.

You stated you may not be in a lower tax bracket at retirement. The money you pay back does not get taxed now, it will earn money tax free in the interim, and it will be taken out at a lower tax rate than if you allow it to be taxed now. Paying it back is a win-win situation. Defaulting will significantly diminish the amount you have available (because of the immediate taxation) to reinvest. You would need to find an investment that provides much higher expected return than the 401(k) investments to make up the difference (although possible to do, it isn't easy).

The only time that it makes sense to default is if you would be in a signicantly higher tax bracket (much more than the additional 10% because of compounding) in retirement than you are now (which could occur if you were out of work for most of the current year).

[Guest rmeigs]

MGB:

The 401khelpcenter.com agree fully with your comments and have never "bought into" the false argument of double taxing on loans. You are not double taxed on 401k loans. We are not sure where the quote from 401kworker came from.

There are many good arguments against the double taxation argument, but we generally put forward one of them. Here is what we say about this issue in our FAQ section (http://www.401khelpcenter.com/faq/faq_29.html):

Frequently Asked Questions

Do you pay income tax twice when you take out a 401k plan loan?

Answer: It is often claimed that one of the reasons that you should not take out a 401k plan loan is that you will pay income tax twice on the amount: first the loan payments are made with after-tax income (that's once) and, second, when you take you take those payments out as a distribution at retirement (that's twice). This is incorrect, you do not pay any more taxes on a 401k loan than you would on any other type of loan. Think about it. You will be paying off the non-401k loan with after-tax income (that's once) and your contributions and earnings in your 401k (you will have the dollars invested in something since you have not borrowed them) will be tax at distribution (that's twice). The taxation is exactly the same whether you borrow from you 401k or from another source.

The real cost is a possible opportunity loss, i.e., you may be able to earn more investing the dollars than you will from the loan interest over the life of the loan. Plus, there is the danger that if you lose or leave your job, the remaining loan balance is going to become taxable income unless you can pay it off.

[Guest 401kWorker]

My apologies to the 401khelpcenter, the quote was a link from their website to msn money. http://moneycentral.msn.com/articles/retir...basics/4714.asp

I now fully agree with you all, in my heart I knew it all along. It is confusing though when many sources refer to double taxation. Although whats left on my loan is a small amount, I will be sending the check to pay it off tomorrow, Thanks for all your help.

[austin3515]

Well 401(k) Worker, what's important is that you learned a valuable lesson. Come to Benefitslink.com next time you have a question!

Everyone doesn't always agree 100% but as you can see from these posts, they agree on about 99%!

Just so we're all clear, you are not double taxed on loans!