Are Loans Taxed Twice??

[austin3515]

I just came across this article in today's Benefitslink newsletter.  I'd be curious to know if others agree that it is factually inaccurate, and significantly so. The author purports that merely because the loan repayments are made with after tax dollars that the comp needed to repay the loan represents a double taxation (i.e., because of every dollar of loan payments = $1.33 of comp).  But the analysis does not take into account that the $10,000 of pre-tax money was received without paying any taxes.

 

So if I take a $10,000 loan and put $10,000 in my checking account, and then pay it back the next day, it does not cost me $13,000. that transaction is 100% tax neutral.  The fact that principal might be repaid through payroll deductions does not change the fact that $10,000 came out tax free and $10,000 goes back in without a deduction. 

 

I have heard many people suggest (and I think it is true) that the interest is in fact taxed twice (I think others have "proven" this is mitigated by other considerations).  But that's a lot different than what this article is saying.  But who knows, maybe I am missing something...

 

http://lawtonrpc.com/401k-loans-double-taxed/

[Tom Poje]

I wouldn't want him handling things for me if that is what he believes!

the logic is flawed, but that has been proven before.

I would agree loans are not usually a good idea, but to say they are double taxed is another thing.

[Mike Preston]

Everything Tom said, squared. This is the danger of blogs and social media. Unbelievable.

[BG5150]

I sent him an e-mail about the flaws this morning.

What people fail to realize is that the taxes will be coming out of their paycheck regardless of it being a loan payment or not.

Look at it this way:

I want to buy a car.  I can either use $10,000 from my savings which has already been taken out of my paycheck and been taxed. Or I can take a loan from my 401(k) plan and have it paid little by little out of my paycheck. (with a little interest on top of that).  Either way, paying for that car, I'm taxed on $10,000.  Later, I will be taxed on the original $10,000 that was withheld and not taxed yet.

The only double-taxation is on the interest.

[BG5150]

I do agree with him that often loans are a bad idea.

But not always. 

[austin3515]

I'm just glad my head is still screwed on right...

[BG5150]

7 minutes ago, austin3515 said:

I'm just glad my head is still screwed on right...

Let's not get hasty...  ;)

[austin3515]

Yeah, that's what my wife told me too :)

[My 2 cents]

For what it's worth, the July/August 2010 issue of Contingencies magazine addressed this topic on pages 10-14, including a column on page 12 labelled "Debunking the Myth of Double Taxation". 

[david rigby]

http://www.contingenciesonline.com/contingenciesonline/20100708?pg=15#pg15

 

[Brenda Wren]

I emailed the author as well.  Pet peeve of mine.  It's like fingernails on the chalkboard when I hear someone say this.

[ESOP Guy]

Oh no that poor guy got an e-mail from me also. 

The logic flaw is he is treating the fact the 2nd set of wages you earn as taxable is unique to 4k loans.  It isn't it would have been taxable regardless if you took a bank loan or a 4k loan.

Also, I think he makes it confusing to talking about effective tax rates.  To me if you just chart out the various facts and look at taxable income if it is double taxed then taxable income should be twice as high with the 4k loan then without. 

[EdgarBeaver]

Folks, what I don't understand is this. The original contribution came from your payroll pre-tax (lets assume). You take a loan and repay the loan with after tax money.

...

...

Then..... one day you retire and withdraw money from your account. There was no basis created for portion of the account that was a loan repayment - that amount gets taxed in the year you withdraw it.

Am I just not getting it? Wasn't this money double taxed? Little help?

[austin3515]

WEll, this is what Austin said, and he seems to know what he's talking about:

Quote

So if I take a $10,000 loan and put $10,000 in my checking account, and then pay it back the next day, it does not cost me $13,000. that transaction is 100% tax neutral.  The fact that principal might be repaid through payroll deductions does not change the fact that $10,000 came out tax free and $10,000 goes back in without a deduction. 

Whether the payments come from payroll deductions or your savings account is completely irrelevant.  It is literally the same question as to whether the money comes out of your right pocket or left pocket. You got the money tax free, paying it back with after-tax dollars is even steven.  I think if you think about it for as long as I have (a wicked long time!) it will start to make more sense...

[RatherBeGolfing]

3 minutes ago, austin3515 said:

WEll, this is what Austin said, and he seems to know what he's talking about:

Whether the payments come from payroll deductions or your savings account is completely irrelevant.  It is literally the same question as to whether the money comes out of your right pocket or left pocket. You got the money tax free, paying it back with after-tax dollars is even steven.  I think if you think about it for as long as I have (a wicked long time!) it will start to make more sense...

An extra "like" for the use of wicked long time on a dragging Friday!

[MoJo]

9 minutes ago, EdgarBeaver said:

Folks, what I don't understand is this. The original contribution came from your payroll pre-tax (lets assume). You take a loan and repay the loan with after tax money.

...

...

Then..... one day you retire and withdraw money from your account. There was no basis created for portion of the account that was a loan repayment - that amount gets taxed in the year you withdraw it.

Am I just not getting it? Wasn't this money double taxed? Little help?

Because you WITHDREW the amount of hte loan from the plan through the loan WITHOUT PAYING TAXES.  You have that money in your pocket ON WHICH YOU HAVE NEVER EVER PAID TAXES ON, and assuming you don't default on the loan, will NEVER EVER pay taxes on.  The fact that you use "other dollars" also in your pocket (on which you may or may not have paid taxes on) is irrelevant.  Money is "fungible.  That "tax free" "distribution" (loan) from the plan offsets the "taxable" "contributions" (loan payments) to the plan, so the net CHANGE in your tax situation is ... wait for ... ZERO (apart from the interest payments - which then involves a "time value of money discussion" beyond this thread).

[EdgarBeaver]

The story doesn't end when you pay back the loan. The account isn't closed and zeroed out. When you take out a loan the money you took out was replaced with after tax dollars. Those same dollars are taxable upon your final withdrawal from the account.

There is no basis created in a qualified plan for loan repayment. Tax is paid twice = double taxed. no? I've gone round and round with this too...and EdgarBeaver is a tired rodent

[BG5150]

When I wrote the author the e-mail, I used a similar example to Austin's.  Here's mine:

$10,000 zero interest loan, one payment.

 

I take a loan, get the check and immediately cash it for $20 bills.  I’ve always wanted to see what 10 grand looks like in person.  I bring the money home and spread it all over my bed.  Take a few selfies and stack it all back up.

Next month, my employer takes out the $10,000 from my paycheck (I must have a very good job, indeed.  Maybe I’m a Retirement Plan Consultant!  ;-) ).  As you mention the taxes come out of it, so I’m $13,333 out of pocket this month.

 

However, I was going to be paid that money anyway, so the taxes would have been withheld in any event.  So, now my paycheck is (only) $10,000 lower.  But, lo’ and behold, I happened to have $10,000 sitting on my dresser from my loan proceeds.  I take that down to the bank and deposit it.

 

So, now I am whole.  No extra tax burden.

[austin3515]

Same idea, but you win by a mile on entertainment value.  Bravo. Bravo!

[RatherBeGolfing]

7 minutes ago, EdgarBeaver said:

When you take out a loan the money you took out was replaced with after tax dollars.

Are you sure?

I take out $10,000.  Unlike BG, I don't  make it rain and take selfies, I just like looking at a $10,000 stack of non-taxed cash. I then get paid $10,000 and I mix my taxed cash with my non taxed cash.  I repay the loan with $10,100 ($100 interest)from the mixed stack and Im left with $9,900 in my stack. Out of my $20,000, $10,100 went to repay the loan. I only paid taxes on $10,000 out of the $20,000.  How much of my loan was taxed twice?

[MoJo]

1 hour ago, EdgarBeaver said:

The story doesn't end when you pay back the loan. The account isn't closed and zeroed out. When you take out a loan the money you took out was replaced with after tax dollars. Those same dollars are taxable upon your final withdrawal from the account.

There is no basis created in a qualified plan for loan repayment. Tax is paid twice = double taxed. no? I've gone round and round with this too...and EdgarBeaver is a tired rodent

There doesn't NEED to be basis in the plan to zero out the alleged after tax repayments on the loan.

Let me give another example (without interest, to keep the numbers simple):

You take out a loan for $10,000 and put it in your left pocket.  You earn $15,000 taxable, pay $5,000 tax, and put the remaining $10,000 in your right pocket.

You then take $5,000 out of your left pocket, and $5,000 out of your right pocket and pay back the $10,000 loan.

The plan (your account) is in the same position it would have been had no loan been taken out.

In your pockets (both of them combined) you STILL have $10,000 (the net after tax total of your taxable income).

Upon distribution of your account, you will pay taxes on the $10,000 (say, $3,000) in there - but that is taxes YOU WOULD HAVE PAID HAD THEIR BEEN NO LOAN AT ALL, leaving you with a net of $7,000.

Had you NOT taken the loan, you would have paid $5,000 on the $15,000 income you earned anyway (leaving $10,000 in your pocket), and $3,000 in income taxes on the $10,000 plan distribution when you take it, for a total tax of $8,000, and $17,000 left in your pocket ($10,000 net earnings and a net $7,000 of your distribution)..

Since you take the loan, you pay $5,000 in taxes on your $15,000 income (putting $10,000 in your right pocket), ZERO taxes on the loan proceeds (leaving another $10,000 in your left pocket).  You then take $5,000 out of each pocket to pay back the loan (leaving $5,000 in your left pocket and $5,000 in your right pocket), and now restore your plan account with the $10,000 repayment.  At this poiint you take a distribution of the $10,000 from the plan, pay your $3,000 tax, and put the net amount - $7,000 in your pockets (I don't care which one). 

GUESS WHAT?  Under either scenario (no loan or loan) and EVEN WITH at least "partial" repayment of the loan with "after tax money" (your right pocket money)  YOU HAVE EXACTLY THE SAME AMOUNT OF MONEY IN YOUR POCKETS (a total of $17,000), and YOU HAVE PAID EXACTLY THE SAME AMOUNT IN TOTAL TAXES ($8,000).

No difference.  None, nada, zip, zilch.  NO DOUBLE TAXATION OF LOAN REPAYMENTS.

QED...

Add in interest, and that does cause some money on which you have paid taxes on to be taxed at distribution, BUT YOU HAVE ALSO HAD TAX FREE USE OF THE LOAN PROCEEDS DURING THAT TIME - which is a time value of money discussion (essentially, that's the "rent" you pay for having the use of the loan proceeds TODAY as opposed to waiting for a distributeable event.)

[ESOP Guy]

Here is my example (as if there aren't enough)

 

As I say above if there is double taxation then it should show up as the person have higher taxable income with a 4k loan vs another type of loan and that doesn't happen. 

Example 1:

1)  I earn $10,000 and put all $10,000 into a 4k plan pre-tax.  At this point my taxable 
income is zero.
2)  I take a $10,000 loan from a bank.  At this point my taxable income is zero.  
3)  I earn  ANOTHER $10,000 and pay the bank back.  (I know I have to pay the taxes so I 
need at some point the $3,333 as you point out.  But we are looking at taxable income not 
how I will pay my taxes.)  My taxable income is $10,000.
4)  I take a taxable 4k distribution of the full $10,000.  My taxable income is now 
$20,000.  You will note I earned $20,000 in wages when you combine steps 1 and 3.  

Example 2:

1)  I earn #10,000 and put all $10,000 into a 4k plan pre-tax.  At this point my taxable 
income is zero. 
2)  I take a $10,000 loan from the 4k plan.  At this point my taxable income is zero.  
3)  I earn ANOTHER $10,000 and pay back the 4k plan.  (Same $3,333 issue but it doesn't 
change the fact if you are right taxable income ought to be higher now then in example 
1).  My taxable income is $10,000. 
4)  I take a taxable 4k distribution of the full $10,000.  My taxable income is now 
$20,000.  It is the same both ways.  If you were correct my taxable income would have to 
be higher here. 

 

Sorry for odd formatting I copy and paste from my e-mail to the guy whose article started this whole conversation and it margins are different it appears. 

[Mike Preston]

As long as EdgarBeaver is neither a retirement plan consultant nor a financial advisor then his lack of understanding should cause no harm.  Otherwise, the tired rodent should be involuntarily re-tired.

[BG5150]

18 minutes ago, RatherBeGolfing said:

I take out $10,000.  Unlike BG, I don't  make it rain and take selfies,

I used to do some in-house education classes at one of my old jobs.  And to illustrate the point further, (this was before the proliferation of camera phones, so no selfies, Thank God), I said I dumped the money on the bed and rolled around naked on it.  (Someone said something to HR and I was told to find another anecdote for my class.  True story.)

[RatherBeGolfing]

7 minutes ago, BG5150 said:

I used to do some in-house education classes at one of my old jobs.  And to illustrate the point further, (this was before the proliferation of camera phones, so no selfies, Thank God), I said I dumped the money on the bed and rolled around naked on it.  (Someone said something to HR and I was told to find another anecdote for my class.  True story.)

Ha ha I believe it, HR are notorious kill-joys.  Humor is such a great tool in education