Double Taxation of Loans

[blue]

Does anyone know of a good article that expalins the myth of double taxation of loans takent from a retirement plan?

[rcline46]

The simple explanation:

You have pre-tax money in the plan.

You take pre-tax money out of the plan and put it into your pocket and do not pay taxes on what you put into your pocket.

You take the SAME pre-tax money out of your pocket and replace the pre-tax money in the plan, just at a later time.

Therefore there is no double taxation. No article needed.

[stephen]

What about the interest on the loan? You are paying the interest with after tax money and when you take it out you are taxed again on this portion.

I believe there are several threads on this topic...

[rcline46]

There is no question there is double taxation on the interest, but it is growing tax-deferred.

[Alf]

Will loans from Roth 401(k) money be triple taxed???

[E as in ERISA]

It's just that you're combining two separate taxable events into one series of events.

Example. You borrow $5,000 for one year. Interest rate 7%. You pay back $5,350. (That $350 was potentially paid FROM after tax amounts so you possibly had to earn say $500 in order to pay the $350 if you're in the 30% bracket). You know have $350 less to use outside the plan. But you have $350 "more" inside the plan. If you take a withdrawal of that $350 immediately, you may pay $105 in taxes on that $350. The "double taxation" argument is based on the fact that of the original $500, you had to pay $150 in taxes when it came out of your paycheck and another $105 when you withdrew the $105. So you netted $245 of the $500 that you originally earned.

But let's compare that to using a $5,000 loan at 7% outside the plan. You had to earn the same $500, of which you pay $150 to the government and $350 to some financial institution. So of that $500, you actually net $0. However, you still have the $5,000 is sitting in the plan and earning money for that year. If you earned the same 7%, then some other institution would be paying you $350 on that money. If you withdrew the $350, you would be paying taxes of $105. You'd still end up with the same $245 change in your financial position.

Either way, you're going to pay $150 tax on the $500 that you earn to pay back the interest to yourself or a bank. Either way you're going to pay taxes on what you take out of the plan. Those are two discrete transactions that are always going to have separate taxation. If you want to call it double taxation, okay. But then you also have "double taxation" whenever you borrow from a bank. You could try and pay less taxes by only paying back the original $5000 and have the $350 unpaid interest deemed. But if you're still earning that $500 outside the plan on which you pay $150 in taxes and also using $105 to pay the taxes on the deemed amount, then you still end up with the same $245 of that $500.

But the real question is what rates you can get and what the investments are doing. If you borrow from yourself, the rates you're earning and paying are going to be the same. (However, you also have to watch to see what you sell the existing investments at and what you buy them back at....You may have a gain or loss). If you borrow outside the plan at a different rate from what your money inside the plan is earning, you may gain from rate arbitrage. If you've got good investments in the plan earning 10%, 15%..., you'd end up ahead if took the loan outside the plan. (If investments are earning less than 7%, you may end up better taking the loan inside the plan to insure a 7% return on that money)

Bottom line: The more significant issue is the question of opportunity cost.

[R. Butler]

Will loans from Roth 401(k) money be triple taxed???

I was actually pondering the motivation for repaying a loan from the ROTH 401(k) source.

[Bird]

I'm not so sure that double taxation (or triple taxation) is relevant to this topic. Money is money; OK, plan or IRA money isn't as valuable as money in your pocket, but the money in your pocket could represent after-tax earnings, tax-free income, gifts, whatever (stolen? ).

As for Roth loans...I'm not sure, but I guess a Roth loan default would come from contributions first, so would effectively be tax-free. Jost think of the loan payments as Roth contributions and decide whether or not you want to make those contributions.

[david rigby]

Try this:

http://benefitslink.com/boards/index.php?showtopic=16641