Are Loans Taxed Twice??

[BG5150]

3 minutes ago, RatherBeGolfing said:

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

The kill-joy was the person who thought I was trying to insert a sex-joke into my explanation.  HR is just protecting their own butts.  (Pun intended)

[My 2 cents]

As a general rule, if an employee complains about something someone else said or did, HR is not going to tell them to get a life.

[RatherBeGolfing]

2 minutes ago, My 2 cents said:

As a general rule, if an employee complains about something someone else said or did, HR is not going to tell them to get a life.

Dont get me wrong, I have nothing against HR or the function they fill. I'm not saying they do it maliciously or even because they want to.  It is just their responsibility to nip things in the bud.  Which in BGs case happens to be butt nekkid rolling in cash  

[Lois Baker]

Folks, I'm not sure the original article in fact agrees that loans are double-taxed; I think he's perhaps stepping through the (admittedly flawed) reasoning in order to make a point.  After walking through the numbers, here's what he says (emphasis added):

Quote

Many financial experts believe that 401k loans are not double taxed. They say that the overall tax treatment of the individual is the same whether he/she takes a 401k plan loan or a loan from somewhere else. An equivalent amount of taxes would be required to pay back a loan from any other lender. I agree. However, that does not change the fact that a participant appears to experience a tax on the principal portion of 401k loans that is more than double his/her incremental tax rate.

The bottom line here may be that the potential for confusion is just one more reason plan loans are a bad idea.

[Mike Preston]

If plan loans are a bad idea, let it be for reasons that actually make sense.  And even if one concludes that they are a bad idea doesn't give license to make stuff up.  Statements like "However, that does not change the fact that a participant appears to experience a tax on the principal portion of 401k loans that is more than double his/her incremental tax rate." are at best simply cowardly and at worst are intentionally spreading "alternative facts" (lies).

[ESOP Guy]

If the author is trying to say loans aren't double taxes his does a very poor job of it.  Here is what he says right before the part quoted above:

Example

Loan origination: $10,000, no tax impact

Loan payback: One $10,000 payroll-deducted after-tax payment. $13,333 in gross earnings needed to realize the $10,000 after-tax payment resulting in $3,333 in taxes attributable to the payment.

Distribution of this $10,000 at retirement: $10,000 taxed at 25% resulting in $2,500 in taxes.

The total taxes paid on the $10,000 used for the 401k plan loan and then distributed at retirement are $5,833 (58%), more than double the amount of $2,500 (25%) that would be paid on a $10,000 distribution at retirement.

I think any reasonable read of the whole thing leaves you believing that your effective tax rate of a loan is 58% vs 25% if you had not taken the loan.  If he thought those numbers were wrong he can have said they are wrong and why in the next paragraph. 

However, sorry if this guy is upset that he is getting so much attention after his web page got noted in your newsletter.  I fully admit I sent him an e-mail calling out his math.  My intention was not to get a guy mad at Benefitslink. 

[RatherBeGolfing]

2 hours ago, ESOP Guy said:

However, sorry if this guy is upset that he is getting so much attention after his web page got noted in your newsletter.  I fully admit I sent him an e-mail calling out his math.  My intention was not to get a guy mad at Benefitslink. 

Unintended consequences.  Here is the thing though, when you are (or hold yourself out to be) a subject matter expert, you have to be able to discuss the theories and and conclusions with those who disagree or fail to understand your argument.  This is especially true when the things you publish are meant to educate others

Just about every business trying to find an edge uses SEO to generate traffic and name recognition.  Blogs and semi-educational posts are very effective tools for SEO.  But you have to be able to take some criticism or engage in a conversation when someone disagrees. 

[Mike Preston]

11 hours ago, ESOP Guy said:

However, sorry if this guy is upset that he is getting so much attention after his web page got noted in your newsletter.  I fully admit I sent him an e-mail calling out his math.  My intention was not to get a guy mad at Benefitslink. 

Guy, where do you come by the information that the author of the misguided post is mad at BenefitsLink?

[ESOP Guy]

I added the word "if" for a reason.    I fully admit I can be over assuming.  I just noted someone from Benefitslink came to his defense. 

[austin3515]

http://lawtonrpc.com/401k-loan/

Another article from our scholar.  Nothing flagrantly wrong here, and he has dropped his double taxation argument. Perhaps we won him over! 

 

[BG5150]

Assume that a participant takes a $10,000 loan for five years at 6%.

The investment experience on that portion of the participant’s balance will be a 6% return for five years. Had the loan balance been invested in the investment options in the plan for the same period, the participant may have earned a lot more. For example, the five-year return on the Vanguard 500 Index Fund through March 31, 2017, was more than 13%.

No it won't.  That would only be the case if the participant pays the entire $10,600 back at the very end of 5 years.

Finally,

it appears that the interest on 401k loans is double taxed. (emphasis added)

Maybe we did win him over a bit.

 

Plus, loans could be a GOOD investment.  In a down market, your loan repayments can often buy back shares at a lower cost that when you originally bought them.  (Not that I advocate this as an investment strategy, just pointing out that taking a loan is guaranteed to be bad.)

[BG5150]

A reason (some) financial advisers are against loans is that they take assets out of funds for which the advisers may be getting paid.

[Peter Gulia]

Has anyone seen an investment adviser's agreement that measured the fee on the whole account, including the loans receivable?

Is it feasible for a recordkeeper to report a plan's account balance to include the loans receivable?

 

[BG5150]

Why would the RK do that?  They want the funds in the market so they themselves can make money, passing a little of it off to the FAs

[ubermax]

On ‎4‎/‎18‎/‎2017 at 5:06 PM, My 2 cents said:

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". 

Page 12 is an interesting read ( thanks Dave R for the link) ; a common point of the inserted article "Debunking .........." and the first full paragraph of the continued main article on the same page is that possibly only the interest paid by the borrower is double taxed ; to me there's a lot of hand waving going on rather than a mathematical demonstration - at first I thought the "Pure Theory Example" would be a solid demonstration but then at the end the author says "This difference 852 vs. 772 is most likely attributable to a double tax on the interest paid" - not a very forceful statement .

I can also see where some would reason that there's a double tax on principle and interest ; assume a principle payment of 100 , interest of 4 and tax rate of 20% ; if the participant repays the loan with after tax payroll deductions , he withdraws 125 to cover principle and 5 to cover interest , i.e. 100 to principle , 4 to interest , & 26 to taxes - this sounds like it leads to double tax on both P&I .

I'd be interested if anyone has a good mathematical proof that proves only single taxation on the typical K loan ?

[My 2 cents]

Don't forget that the 100 withdrawn as a loan from the plan is subject, at that time, to 0 taxes, so you get to keep (or use) the 100 on a fully tax-free basis.  You could as easily repay the loan from that and not have to take 125 from payroll to repay it.   You were going to pay 25 in taxes on the payroll money in any event, and you would then have 100 in after tax money from payroll to use as you please instead of using it to pay back the loan.

Receipts:  100 from plan, 125 from payroll (total 225)

Expenditures:  25 taxes on payroll, 100 repaid to plan from any or all available sources (plus interest, which is here being ignored), 100 left for any other purpose. (total 225)

When the money is later withdrawn from the plan (not borrowed), THEN you pay taxes.  Once.

Does that help?

[ESOP Guy]

1 hour ago, ubermax said:

I'd be interested if anyone has a good mathematical proof that proves only single taxation on the typical K loan ?

I think I put one in this thread all ready I showed that the total taxable income of taking a 4k loan and not taking a 4k loan is the same assuming no interest is paid.  If the taxable income is the same with and without taking a loan there can't be double taxation. 

 

I know there are other threads on this board over the years were people have put spreadsheet as attachments showing the same.

[MoJo]

6 minutes ago, ESOP Guy said:

I think I put one in this thread all ready I showed that the total taxable income of taking a 4k loan and not taking a 4k loan is the same assuming no interest is paid.  If the taxable income is the same with and without taking a loan there can't be double taxation. 

 

I know there are other threads on this board over the years were people have put spreadsheet as attachments showing the same.

I posted a similar example as "proof" above as well.

[MoJo]

On 5/2/2017 at 1:55 PM, BG5150 said:

Why would the RK do that?  They want the funds in the market so they themselves can make money, passing a little of it off to the FAs

As time goes by, and with more fee transparency, what the advisor is paid is less and less relevant to what the recordkeeper is paid.  If there isn't enough from "rev share" to pay both, hit the account balances.  It's up to the plan sponsor to determine if the fee paid to the advisor (whether based on the loan balances or not) is reasonable.

And yes, I've been with recordkeepers who have, at the direction of a plan fiduciary, done this.  Loans are in fact part of the plan balances....

[ubermax]

2 hours ago, My 2 cents said:

Don't forget that the 100 withdrawn as a loan from the plan is subject, at that time, to 0 taxes, so you get to keep (or use) the 100 on a fully tax-free basis.  You could as easily repay the loan from that and not have to take 125 from payroll to repay it.   You were going to pay 25 in taxes on the payroll money in any event, and you would then have 100 in after tax money from payroll to use as you please instead of using it to pay back the loan.

Receipts:  100 from plan, 125 from payroll (total 225)

Expenditures:  25 taxes on payroll, 100 repaid to plan from any or all available sources (plus interest, which is here being ignored), 100 left for any other purpose. (total 225)

When the money is later withdrawn from the plan (not borrowed), THEN you pay taxes.  Once.

Does that help?

Thanks My 2 cents , good example and I guess when you consider interest you come back to that Contingencies article which seem to point out that the interest is double taxed .

[ESOP Guy]

Observations on the double taxation of the interest:

Someone is going to pay taxes on the interest.  It can either be you or a bank you borrow the funds from.

I would add too many people let the tax tail wag the dog.  You are still better off after double taxation paying it to yourself than the bank as long as the double tax rate is less then 100%.

Simple example:

You are going to pay $100 in interest on a loan regardless of the source of the loan. 

If you pay it to a bank you have $100 leaving your net worth.

If you pay the 100 to yourself and your effective rate of taxes because of double taxation is a whopping 80%.  That means you will pay $80 to Uncle Sam and have $20 still as part of your net worth.

Which one are you better off with?

I am ignoring opportunity costs of what your 4k funds could have earned if they are stayed in the 4k plan.  I think that can be real but it isn't a tax question.  If you are looking at taxes and only taxes a 4k loan isn't a bad deal. 

These loans can be a bad deal but it is the other reasons people talk about.  Too many people get the tax issue wrong on these loans wrong. 

[Lou S.]

I think the biggest argument against Participant Loans is the default rate when you leave the company with an outstanding loan.

I mean often you are hit with a tax bill for income you spent a year or more ago at a time when you may now have no current income.

Personally I hate participant loans but they aren't going anywhere anytime soon that I see.

As for the double taxation. No the principal replaces principal that has never been subject to taxation and the interest is taxed just like any other gains of a retirement plan.

[austin3515]

I know what needs to be done...  They need to allow people to continue making payments to IRAs after they terminate.  Your loan called for $100 twice a month? Deposit $200 to your IRA (no less than $600 a quarter) and you can defer paying the taxes.  Banks will set up ACH's.  They will report whether or not the participant "defaulted" by not making the necessary payments each quarter.  We'll find a way for the plans to tell the banks what the loan specs are.  I can see a PenChecks jumping at the chance to add "participant loan IRA's."

I'm going to write my Senator!!

[MoJo]

29 minutes ago, austin3515 said:

I'm going to write my Senator!!

Hmmmm.  OK.  Congress is currently trying figure out how to get $2.3 TRILLION dollars over next year, since the AHCA (which they counted on for $1 TRILLION of that) isn't going to save anything EVEN IF IT GETS PASSED), and the "Border Adjustment Tax ("Make Mexico Pay for the Wall") is a non-starter in either party.  There is talk of reducing the 402(g) limit, allowing only half of the 402(g) limit to be pre-tax with the remainder being Roth.  They are talking about eliminating any NEW pre-tax IRAs, and eliminating any new pre-tax CONTRIBUTIONS  to existing IRAs (Groom law called it the "Rothification" of the system at a conference I was at earlier this week).

And you think your Senator is going to propose PRESERVING a "tax expenditure" by allowing fewer loans to go into TAXABLE default?

Pass that funny looking cigarette this way, please....

[austin3515]

Oh MoJo, I guess you got up on the same side of the bed as usually do.

Do I think that legislation that helps the "poorest" Americans preserve their retirement nest-eggs will prove to be a popular idea on both sides of the aisle?  Yes, I do.  Realistically we are not talking about a change, at least in my opinion, that is going to break the bank.  I know that 1/5th of the US economy was not important enough to get a CBO score before passing legislation in the House, but I think my change is critical enough to warrant that simple task.  I'd venture a guess that most people will default.

I'm dealing with a situation now where someone took a $40K loan and his employer was sold just 6 months later.  He either writes a $39,000 check or defaults.