Discussion on Loan Payments and Double Taxation

[Dennis Povloski]

I thought I remembered seeing a good discussion somewhere (I think on BenefitsLink) that went over the issue of Participant loan payments being made with after tax money, and then the interest being paid back into the plan is taxed again when the funds are distributed at retirement. So in essence, the participant pays taxes on the funds twice.

Maybe it was an article in the newsletter instead of a posting on the message board.

Anyone recall that, or anything like that?

Thanks!

Dennis

[ETA Consulting LLC]

It's all just a play in ideology versus math. Any loan repayment (whether to a Plan or Bank) is made with post-tax dollars. The interest payment on the loan goes in as pre-tax earnings, simular to any investment return on any plan asset. The only issue is that these interest payments are from dollars that you are paying (either from your checking account or withheld from your paycheck after taxes have been withheld). So the equation becomes either pay the interest to someone else, or pay the interest to your plan. Either way, it's a wash. The argument on paying tax twice was more idealistic than mathematical given that all loan payments (weather made to a bank or a plan are made with post tax dollars).

Good Luck!

[rcline46]

Interest payments are 'after tax' money, that is clear. Principal payments are replacing the 'pre-tax' money that was borrowed, and therefore are 'pre-tax' money. Say the principal payments are after tax money betrays a fundamental lack of understanding what is happening.

[masteff]

Say the principal payments are after tax money betrays a fundamental lack of understanding what is happening.

Agreed!!!

The money was not taxable to you when it was loaned out of the plan. When you repay the money, it keeps the character it had when it was loaned (ie if it went out from pretax then it goes back to pretax). You have a personal liability to return $X dollars of pretax money plus interest to the plan. The fact that the particular dollar used to repay the loan came out of your paycheck aftertax does not change the nature of the liability being repaid. (This goes back to the fact that money is fungible, so it is technically irrelevant that a particular dollar originated aftertax from your paycheck.) The nature of the liability is what matters.

[ETA Consulting LLC]

6 in one hand; a half-dozen in the other. If the principal payments were pre-tax, then they would be subject to the $16,500 limit (which applies to pre-tax amounts withheld from employee pay). Think about it

[rcline46]

Erisatoolkit - it is talking like that which confuses people. I doubt you really believe what you said. Masteff said it correctly.

To put it another way, you took a loan of pre-tax money and put it into you pocket and spent it instead of spending post-tax money. You now have to replace the pre-tax money. If you were truly using post-tax money, you would get a basis in the plan (and of course it would be subject to ACP testing!). It is not a new contribution subject to the 402(g) limit or ACP testing. It is replacing money that retains the pre-tax flavor (ignoring ROTH money).

[ETA Consulting LLC]

I actually do believe what I said. Whenever we commuincate a point, it is imperative that we maintain the appropriate vantage point of the argument. My original comment for Dennis was to state merely that regardless of who you pay (Plan or Bank), you are paying money that has already received the same tax treatment. If I borrow $10,000 from my plan and pay $1,000 per month, that $1,000 payment can be paid from my checking account or from an amount that was withheld from my paycheck (after all taxes have been paid). That equation remains consistent, regardless of who the lender is. That was point number one.

Now, as that payment goes into the plan (assuming the loan is from the plan), then a portion goes in as principal repayments and the other goes in an earnings on the investment (e.g. outstanding loan balance). This is the same treatment that would be the case if the payment had been made to a bank, instead. One portion would be treated as principal, and the back would have to record the interest payment as "profit" which is typically taxable.

Nothing changes from the person taking the loan; the payments will be made with money that has already been taxed. The only thing that changes is who is the lender. Regardless of who the lender is, the "interest" will be treated as the rate of return on that investment.

Not intending to be confusing, but to say anything different would be to imply that the participant is being hit with an additional set of taxes going beyond what would be required had they borrowed the funds from any lender other than the plan; a confusing point in my book.

Good Luck!

[BG5150]

I came up with (what I thought was) a good example.

Say you take a loan for $10,000. You go to the bank with the check, and cash it for singles, just to see what 10,000 bills look like. You don't spend it on anything, just look at it, maybe take pictures with it, or whatever.

Then, a day or two later, you put it back in the bank, and write a check to pay off the loan for $10,100.

So, now, you have only used $100 of your money (after-tax money). At the end of the day, you have only been taxed already on that interest payment.

Therefore, the principal payment is NOT taxed twice.

[ETA Consulting LLC]

Correct; 1000%. Also, you can substitute "Retirement Plan" for "Bank" in your analysis, and it would be equally true.

I like your example

[masteff]

6 in one hand; a half-dozen in the other. If the principal payments were pre-tax, then they would be subject to the $16,500 limit (which applies to pre-tax amounts withheld from employee pay). Think about it

The flaw in this is the difference between contributions/annual additions and loan payments. Do you include loan payments in calculating the annual additions limit? No. A loan is a receivable on the books of the plan, technically an investment of the plan, and a liability on the books of the borrower.

[ETA Consulting LLC]

I don't disagree with that. My only point is that:

To suggest that a participant incurs additional tax by taking a plan loan as opposed to a loan from another source is misleading and simply not true. When we use the term "double taxation" to describe a recordkeeping function, we should be mindful not to imply that that participant is somehow paying additional tax that he would otherwise pay had the money been borrowed from a bank.

I am impressed with our knowledge of recordkeeping, annual additionals, 402(g) limits and everything else.

Without engaging in this semantical discussion, can we all agree that the participant does not incur any additional taxation by taking a loan from the plan as opposed to taking the loan from a bank?

[GMK]

Somebody pays the tax on the interest payments.

If you pay the interest to the bank, then the bank pays the tax on it. If you pay the interest to your account, then you pay the tax on it when you take the distribution. yes/no?

[ETA Consulting LLC]

Yes. Correct. So, should you forego taking the loan from the plan and instead take it from the bank in order for the bank to pay the tax on the interest instead of you.

The net result may be that instead of earning a "loan interest" rate of return, you earn an "rate pursuant to your investment mix" while you pay the bank the payments. You are still going to be taxed on your distribution from the plan when you ultimately receive it.

So, my question again.... Is there any tax that the participant would pay for taking a loan from a plan that is above and beyond what would be paid if the participant were to take the loan from a bank?

That is my question. My contention is that the answer is no; making any discussion of double taxation confusing and misleading.

[K2retire]

So, my question again.... Is there any tax that the participant would pay for taking a loan from a plan that is above and beyond what would be paid if the participant were to take the loan from a bank?

That is my question. My contention is that the answer is no; making any discussion of double taxation confusing and misleading.

Agreed!

[Tom Poje]

one such article can be found here

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

the discussion of double taxes on interest (not princiapl, its obvious that is a myth) began somewhere around page 6, the conclusion being that while yes, the effect was minimal.

math geeks will love the appendix at the end, maybe back in the old days I would have appreciated it.

[masteff]

Excellent find, Tom!

From Appendix 1: "The key point of this exercise is that the present value of taxes and consumption are identical in the “loan” case and the “no-loan” case."