401k Loan versus ROTH 401k Loans

[Guest Firehawk734]

Hi, I'm new here and dying to ask some good questions. Myself and some co-workers have been racking our brains over these.

I have what I think is a dandy of a set of questions.

First one, with regard to double taxation of a traditional 401k loan. I don't see how the loan portion is not double taxed when you consider the retirement part (not just when you take the loan and pay it back). When you pay back the pre-tax money, you pay it back with after tax money. Then at retirement, when you take a distribution, you pay tax again on that money that was borrowed at some point. So that, to me, is a double taxation is it not? THere's alot online talking about double taxation, but the articles never include the distribution tax (which will vary depending on the size of the tax) at retirement. I am always trying to think long term.

Second one, much more involved, and I have to give a bit of backstory.

I've been at my company for 13 years now, started when I was 21. I am 34 now. WHen i started, I opened a traditional 401k account. They did not offer ROTH 401k accounts until THIS YEAR. They match 6% no matter which account you contribute to.

So, if you're answering this question, you know that the Roth 401k means you pay after tax contributions, then don't pay taxes anymore on that money when you take distributions at retirement. The opposite is true with traditional 401ks, you pay pre tax contributions to your account and then pay distributions at the ordinary income rate depending on the size of the distributions.

SO, now for the interesting part.

Would it be beneficial to borrow against a Roth 401k instead of from a Traditional 401k?

It seems to me that I could exponentially build up a Roth 401k in a more tax efficient manner by at first maxing out the contributions for say, 2 years (17.5k x 2 years = 35k), and then at the end of 2 years, borrow 50% of the balance. I then set up a loan repayment for a term of 1 year and drop my contribution rate down to 6%. The money I borrowed is kept in a savings, to supplement income or to hold in case of some emergency, where I need to pay that loan back off in the event I might lose my job. But, I could effectively save up a lot more than the 17.5k limit per year because you end up paying back that loan quickly (1 year), and then take out a loan for more and more until you reach the 50k limit). This takes some years to achieve obviously. But you never have to worry about distributions ever again becuase you've already paid the tax.

And, you're going to pay the tax on your income ANYWAYS, whether i borrow against the Roth 401k and pay it back with after tax money, or not borrow from the Roth 401k and put the after tax money in my savings account. It's just a way to possibly 'loophole' yourself to a higher contribution.

Thirdly,

I called my HR dept. and also called Wells Fargo advisors and both told me I cannot distinguish where the money comes from if I were to take a loan out. Say I had 100k in a 401k and 100k in a Roth 401k. Then say I apply for a 50k loan. I cannot choose to remove 50k from the Roth 401k specifically. The WF advisor says it all comes out of the 'pile'. There are 2 separate balances, but it is all considered 1 pile to borrow from. I thought that was a little bit silly. I stated that this has major tax implications at Retirement, becuase I would never know how much money came out of which account, and at retirement the taxes on distributions are different. The WF advisor told me in this case money would be pulled equally from both balances. Seems a bit strange. What if I had 100k in the traditional and 20k in the Roth? Are they gonna pull 5 times the amount from the traditional then? Seems odd to me.

That's a lot to stew on. Any views on this would be appreciated.

[rcline46]

Firehawk734 - use the search function on 'double taxation'. There are prior threads on this. the interest paid is double taxed, but not the principal. Thinking it is double taxed is just fuzzy thinking.

I do not follow the idea on borrowing from the Roth K account, probably my fuzzy thinking this morning. The only advantage (possibly) is that the interest you pay back may be higher than the earnings in the plan (a plus), but may be lower (a minus).

SInce you self-direct investments, you can most certainly direct where your loan money comes from. Anyone who tells you differently just has not read their documents. All firms use a 'default' loan process, but the participant certainly can choose.

[Tom Poje]

as a real simple example.

let's say you defer $100 (pre tax).

you immediately turn around and take a loan for $100 and stick it in a drawer at home, ready to spend the next day but you forget about it.

Let's suppose somehow there was no interest charged. one day months later you trip across the $100 in the drawer so you pay back the loan. Certainly no double taxation on the $100.

It's because you put $ in pre tax and then took thenm out without tax, it just doesn't seem that way when you eventually pay the loan back.

technically there is a double taxation on the interest, though if you find one of the links rcline mentions it is supposedly minimal.

I hadn't thought about the Roth issue, nor have I read anything about it, though I guess since its a Roth account you would avoid the issue of double taxation on the interest.

I think the reason for a negative attitude toward borrowing from Roth is if you fail to pay things back (e.g. you quit) then you have the penalties that accompany early withdrawal from a Roth.

[Belgarath]

Firehawk - I must say I can't follow your thinking on the Roth loans. Perhaps you might post an example showing the relative annual flow of money and balances to illustrate your position.

Rcline - I respectfully disagree with your premise regarding directing where the loan money comes from, if I properly understand what you are saying. Sungard,for example, which is a big document provider, provides an option for the plan to restrict the source of loans/distributions, and many plans do in fact prohibit distributions/loans from Roth accounts. But maybe you were really saying something else, and I'm misinterpreting your meaning?

[rcline46]

I know our software allows you to identify the sources from which you can take money (Relius), and you can include/exclude sources at will. I see nothing in the documents that say you MUST take prorata. Administrative procedures can be set willy-nilly. So I firmly believe the participant can direct from whence the money comes. Otherwise, the person making the transaction becomes a fiduciary by making investment decisions!!!! (That is the purpose of the default choices).

[masteff]

The participant can only choose the source of the loan if the plan permits it (not the software). A fair number of plans specify a hierarchy or absent that do it prorata.

As to the double taxation question, as rcline said above, it's faulty logic. See the document from the Federal Reserve in the 2nd link in post #12 of this thread: http://benefitslink.com/boards/index.php?/topic/46277-double-taxation-on-loan-repayment/ (My spreadsheet in post #9 is a useful visual aid too.)

As to your plan for taking loans to get rich. 1) you appear to incorrectly assume that you'll always have a higher rate of return from the loan than from other investments (in fact interest rates are so poor right now that nearly any other investment will perform better over the long term). 2) the maximum loan rules will never result in your goal of a continuous loan because subsequent loans may be reduced by the highest outstanding balance in the previous 12 months.

[Guest Firehawk734]

Hi Guys,

I don’t think you can argue against double taxation on a traditional 401 by saying you take the loan and then the next day pay it back…maybe you could, but to me it’s a bit silly.

Anyway, the more I think about, the more I think I’m wrong about the double taxation, and also wrong about the Roth 401k and leveraging it. Let me explain, and people can certainly chew it up and spit it back at me if they like. I’m looking for agree/disagree, I am trying to learn.

Anyways,

Regarding the double taxation, I think I was forgetting about the tax deduction to begin with. If you take a loan out for 10k, you get to take a 10k deduction on your taxable income. Borrowing it at some point is like waiving the tax deduction (still so far you’re no worse for wear, as otherwise you would be taxed anyway and it would end up in your savings account. So, net net, you waive your deduction. Then you get taxed at distribution time in retirement. Excluding interest, I’m now thinking this explains how the principle is not double taxed. The first taxation is a wash essentially (it’s like the penalty for taking a loan, which is another story and I honestly think should be permitted to pay back pre tax money with pre tax money, but that has other consequences).

Regarding the idea I had about leveraging up the Roth 401k, doing what I suggested only gets you further ahead by the 3.25% interest you pay back to yourself. Otherwise, you might as well max the account out at 17.5k a year and put the rest in savings. It’s all taxed money anyway. I was forgetting that when you start with 100k in the account, you take a loan with 50k (so now you have 50k in the account). Yes you now have 50k in your SAVINGS account, but when you pay the loan back over a year, you end up with 50k + max contribution (17.5k) + 3.25% interest + 50k principle (so 117.5k, not 167.5k . So, if you never took the loan you’d just not have the 3.25% interest in there.

Now there is a nice perk with regard to borrowing against your loans. If you have 100k+ in there, you can borrow the money, and have more free money to use as you see fit (it’s not restricted to only investments in some investment account). But you have consequences to this, like tax free/deferred growth.

I think I was overthinking the problem I was thinking of .

[MoJo]

I think you are over analyzing the double taxation issue. Money is fungible (one dollar is equivalent to another dollar). You are ascribing the tax status of the dollar you use to repay a plan loan - that it is an after tax dollar you had to earn and pay taxes on before applying it to the loan - to suggest that you are double taxed when that same dollar is distributed to you upon retirement. No. The dollar you took as a loan STILL EXISTS - in that you received something of value when you used that loan for what ever purpose you took the loan - whether it be buying a new TV, or paying other bills, or the entertainment value of a vacation, the value exists. When you repay the loan, the CHARACTER of the dollar you BORROWED is attached to dollar you are using to pay back the loan (which is a "pre-tax" character). You still have the TV or the lower balances on the bills you paid, or the value of the vacation or whatever you used the loan proceeds for. you've simply exchanged the dollar for someting (you perceive to be) of value.

I would argue the same is true of the interest on the loan. It's a premium for obtaining what you've acquired sooner rather than waiting till you had enough "after tax" dollars to obtain it.

Think of it all this way - as discussed above. Take a $100 loan. Put it under the mattress. Take your year end bonus (net) of $100. Pay back the loan with the bonus money. You aren't double taxed on anything as you are in exactly the same tax position you would have been in under any other scenario. Just because the "dollar" you "use" to pay back the loan was one you've paid tax on doesn't change the transaction.

Consider another example. Take a $100 loan. Inherit from your old Great Aunt Hattie (great in many ways, not least of which she remembered you in her will). Your "inherited dollars are "tax free" - and if you use them to pay back your loan - nothing changes. You don't get a "deduction" because you are now paying back a loan with tax free dollars, just as you are not double taxed if paying back the loan with "after tax" dollars.

Money is fungible.

Sorry for the rant, but I'm tired of the "double taxation" discussion continuing in this day and age (and I even see some of the major service providers spouting this nonsense).

[MWeddell]

It seems to me that (in general) any loan repayment is made with after-tax dollars, so that's not a point of differentiation when comparing a loan from a qualified plan with a loan from a third party.

[masteff]

doing what I suggested only gets you further ahead by the 3.25% interest you pay back to yourself

To repeat myself, this assumes that the money in your 401(k) account is invested in cash and not otherwise invested. If the money was invested, then the money would experience growth and dividends/interest. So if the stock market returned, say, 10% but your loan was at 3.25%, you just lost out on 6.75% of growth. This lost earnings potential is the "opportunity cost" of taking the loan from your 401(k) account.

If your 401(k) account is being held in cash, then you seriously need spend time on a site like MotleyFool and learn about investing.

[MoJo]

It seems to me that (in general) any loan repayment is made with after-tax dollars, so that's not a point of differentiation when comparing a loan from a qualified plan with a loan from a third party.

Except that ultimately you get the money you've paid against the loan as a distribution when you have a distributeable event - which is what cause many to think there is a tax issue.

You are, of course, right - but that doesn't stop others from jumping on this particular "gerbil wheel."

[Guest Firehawk734]

You can't assume because money is invested it will grow. Sorry. But I get what you are saying.

The more I talk it out and think it through, i think I was still wrong in my second post in this thread.

If you have 100k in a traditional 401k loan, you borrow 50k from it, you are replacing the money with after tax dollars. That money would be taxed ANYWAYS, it's just like you are fronting yourself the money. So now I see how it is not double taxed. The only difference is that interest you pay to yourself.

If i wanted to borrow 50k to put into my savings account, I would essentially have to earn more than 50k+3.25%(50k) to make it worth while, excluding any investment growth/appreciation/losses.

So, in a sense, if I didn't need to, I shouldn't borrow it. I should just continue to try to save on my own, shy of needing to take a loan I guess.

It helps to really think it out and talk it out.

My ultimate circumstance is that I would like to retire before the minimum age of 59.5. I don't really care about overall net worth, I care that I can retire and live on interest and dividends and not have to work anymore. I realize this idea is far fetched to some people, to retire early, but that's what i would like to do. So my entire reason initially for starting my posts here was to try to build that taxable account as high as possible, and as tax efficiently as possible.

Now I could lower my contribution rate on the traditional 401k to 6% (that's what the company matches up to), but now I'm going to have a higher taxable income. Probably wise to just continue to save as much as I can I guess, without doing the loan thing...

It's a good discusion guys, thanks for participating so far.

[K2retire]

"If you have 100k in a traditional 401k loan,"

You don't have the money in a 401(k) loan until you borrow it. And you can never borrow more than $50,000 at a time.

You got a tax deduction for your salary deferrals when you deposited them. You have not paid tax on any money your employer put in. When you take out a loan you do not pay tax UNLESS or UNTIL you default on the loan. So whether it's in the plan or under your mattress, you still have not paid tax on those dollars.

If you pay it back with money that you earned (from a job or investments) you will be paying it back with money that has been taxed. But if you pay it back with money that you received as a gift or inheritance, you will be paying it back with untaxed money.

None of that is relevant. You are not double taxed on money you borrow from a retirement plan.

[Guest Firehawk734]

Yep, the important thing to remember is loan proceeds are never taxed.

[Guest abwd2c]

I think the key thing to remember when planning all of this is that the rules on plan loans are general at best and plan's terms can severely limit the benefit of any plan loan. First, a plan can preclude contributions while your loan is outstanding, so the hit to your potential retirement savings is much more substantial. You could be effectively foregoing contributions up to 5 years (15 if loan for a home) to get this loan. Second, termination is a huge risk. Requires immediate payback, or inclusion of oustanding balance in income and that amount is subject to the 10% penalty. However, this type of arrangement can work if your employer continues to allow you to make contributions while the loan is outstanding, and your loan is essentially treated as the bond portion of your investment plan or your overal return on your plan investments is fairly conservative. And even though the interest is double-taxed, the earnings on such are not.

[Guest kman4ever]

I think this is simple...

If you borrow from your pre-tax 401k it doesn't count as income so when you pay it back why should you get a tax deduction?

The interest you pay will be new money into your account. This is paid with after tax money and when you take a distribution you will be taxed on this money again...but think of the alternative. If you borrowed money from a bank you would pay them the interest entirely...isn't it better to pay yourself back and pay a small portion in taxes?

Alright example:

Year 2013

W-2 earnings: 100,000 (this would have been you taxable income if you didn't have a 401k)

401k deduction: 10,000

taxable income: 90,000

You take a loan in 2013:

Loan: 5,000

Pay back the loan in 2013: 5,000 principal; 100 interest

Taxable income remains: 90,000

you take a distribution in 2013 because your retired...

you made no gains on your investments

distribution: 10,100 (right because you contributed 10,000 borrowed 5,000 paid back 5,100)

taxable income: 90,000 + 10,100 = $100,100

So you see young grasshoppers you were never double taxed except for the 100 which would have gone to a mean old bank if it wasn't for your 401k plan.

...and that's the facts...jack.