Double taxation on loan repayment?

[Guest Spock]

Some people argue that dollars used to make 401(k) loan payments are taxed twice; once when the loan is repaid with after tax dollars and a second time when the account balance is distributed. But isn't there an argument on the other side, as well? A participant does not pay tax on the initial deferral, nor do they pay tax on the loan proceeds, so the deferral is maintained. If loan payments were tax deferred a person would in essence get a double deferral on the same money. Does anyone have something already prepared that argues that loan repayments are NOT taxed twic?

Thank you.

LL&P

[K2retire]

Retirement plan loans are taxed exactly the same as any other loan. You pay no tax on the loan proceeds and you pay it back with after tax money.

[Tom Poje]

yes and no.

suppose you defer $1000. you have not paid taxes.

you take a loan for $1000.

you put the money under the matress (still no taxes) , and a month later pay back $1000 with the cash from under the matress.

you still have yet to be taxed, so you will never pay double taxes on the "principal".

so why would it make a difference if you spend the $1000 and pay it back by other means? It doesn't. That initial $1000 was never taxed in the first place.

Arguably on the amount of interest you will get double taxed, beacuse you do have to come up with $ for that, and those $ have been taxed, but supposedly their are studies that show even this overall amount is minimal.

If its Roth money then the interest payments are like being able to make extra contributions (with taxed money), but then you pay no taxes when you withdraw.

............

so you have the choice: borrowing hurts you more so beacsue you pull out $ that could be getting gains (if you took a loan before the crash you have come out ahead)

or instead of borrowing from the plan, just use your charge card and pay 18% interest or whatever to someone else. much better than the possible effects of being double taxed on the interest portion.

[movedon]

Arguably on the amount of interest you will get double taxed, beacuse you do have to come up with $ for that, and those $ have been taxed, but supposedly their are studies that show even this overall amount is minimal.

And in any event, if your choice is between a loan from a bank or a loan from the plan, you are better off "paying" interest in to your plan account and losing a little of it to tax later than paying the interest to the bank and losing it all now.

[masteff]

Part of the confusion about loan payments being made w/ "after-tax" dollars is that's how it shows on a person's pay stub. They confuse treatment on their pay stub w/ the actual treatment of the money going in and out of the plan. It can make it easier to illustrate using "coupon book" payments rather than payroll deductions.

[BG5150]

Arguably on the amount of interest you will get double taxed, beacuse you do have to come up with $ for that, and those $ have been taxed, but supposedly their are studies that show even this overall amount is minimal.

And in any event, if your choice is between a loan from a bank or a loan from the plan, you are better off "paying" interest in to your plan account and losing a little of it to tax later than paying the interest to the bank and losing it all now.

However, your retirement plan is supposed to be a long-term investment. IF you remove money from it, you might be robbing yourself of the compounding gains on the money in the account. (Though some people argue that in a down market, a loan may be beneficial, as you'd be buying back the shares at a lower cost. However, I'm not sure if that would outweigh the benefits of staying in the market, but perhaps in a different investment.)

[masteff]

When I took a small loan to pay for some needed remodeling, I actually treated the loan as an investment choice and adjusted my portfolio accordingly. Whereas a portfolio might include a percentage in bonds (which generally bear a fixed rate of return), I simply substituted my plan loan from what I might otherwise have in bonds (replacing one fixed rate of return with another). This meant manually adjusting my portfolio after the loan was distributed prorata from my investments. The only problem w/ this philosophy is people who take the max 50% of their balance loan as few people should really be 50% invested in a fixed rate of return investment in a tax deferred account.

[austin3515]

Tom seems to have slipped something very interesting in here that I wanted to call more attention to. So if the loan is taken from the Roth account, then the double taxation on the interest (which in my opinion is irrefutable) is completely avoided if the money is taken from the Roth account (assuming it is later withdrawn as a qualifying distribution).

That's a pretty important aspect for the people who take out $50,000 loans for 5 years (which is the only time I even bring it up).

[masteff]

Good catch austin, I'd overlooked that point of Tom's earlier. It would definitely argue that all plans should put Roth account as #1 source for loan in their source heirarchy.

As to double taxation of interest portion of the loan payment... yes, it's double taxed BUT it would be double taxed regardless of who you paid the interest to and whether the loan was inside or outside the loan; someone pays tax on it even if it's not you. If you took a commerical loan and made payments to them, they would pay tax on the interest. The difference is that w/ a plan loan, you get to defer the tax. Furthermore, the growth and earnings you might have otherwise earned (if you hadn't taken the loan; Roth excluded) would be taxed. If I put $5000 in a stock that pays a 5% dividend, then I pay tax on that 5% when I eventually w/draw the money; if I take a $5000 plan loan at 5%, then I pay tax on that 5% when I eventually w/ draw the money. So there is no net negative consequence w/ regard to how much tax is paid.

Edit: added excel attachment to illustrate zero net tax effect of a plan loan

zerotaxeffectofinterestonplanloan.xls

[Tom Poje]

the other point in regards to Roth:

if you set one up in a 401k, its probably a good idea to set up a personal one (no matter how small) outside the plan as well. that starts the 5 year clock ticking.

if you terminate, you can then roll your distribution into your Roth. you do not have to wait an additional 5 years before touching the money again.

[austin3515]

Wow... So I guess what I must have missed in all of those financial articles is that the double taxation is only an issue if the alternative is NOT taking a loan at all. Would you agree that if you are deciding whether or not to take a loan in the first place, the double taxation still applies? Let's say for example option 1 is liquidating a personal savings account, and option 2 is the participant loan.

Yet again, something I thought was clean cut is not

[austin3515]

http://www.401kplanning.org/top-401k-plann...on-a-401k-loan/

This article is interesting and referneces a study by the Federal Reserve (there's a link in this article)... I don't pretend to follow the logic, but it seems to be that while the interest IS double taxed, there are tax advantages that neutralize this, as long as the "discount rate and the loan interest are assumed to be the same" (as in masteff's example).

I presume masteff's example is built on the same logic the fed was using, and is simply presented in an easier to understand format. So although regrettably, I would not be able to explain this phenomenon to a client, it appears that there is one less downside to borrowing from a plan.

See section 3.2 of fed's write-up. I believe them, I'm just not sure I follow why the making after-tax payments over 5 years offsets the double taxation of the interest, but they're the fed, so I'll believe them!

http://www.federalreserve.gov/pubs/feds/20...2/200842pap.pdf

[movedon]

I haven't read the article, but I would imagine it goes into the complex analysis (to me, anyway) of the tax consequences of various options. While the interest is double-taxed, in theory the proceeds of the loan, to the extent they earn any return in their use, create currently taxable earnings outside the plan, while the deposited interest goes on to create tax-deferred earnings inside the plan. I've considered this, and I think the entire analysis becomes one of too many variables - assumed rates of return, tax rates that may change over time (both personally and policy-wide), interest rates, etc. Hopelessly unpredictable if you ask me. This could detriorate into a conversation about whether pre-tax savings is even a good idea in the first place, given unknowable details like the above. Perish the thought!

The bottom line, as far as I'm concerned, is that taking a participant loan is likely an option worth considering if you need a loan and your alternative is going to the bank - interest double-taxed is still better than interest paid to the bank. Of course, even there we have to dismiss (as BG pointed out above) the lost earnings you endure on the money removed from the plan. In any event, taking a participant loan is probably never a strategy to improve your retirement savings, even in a Roth account. Theoretically you put the money in the account in the first place to create retirement savings down the road, on the assumption that the contributions would earn returns over time. The money isn't earning a return if you take it out to buy a boat. IMHO.