Are Loans Taxed Twice??

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/

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.

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

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.

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

But not always. 

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

7 minutes ago, austin3515 said:

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

Let's not get hasty...  ;)

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

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". 

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

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

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. 

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?

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...

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!

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).

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

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.

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

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?

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.)

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. 

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.

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.)

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

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)

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.

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  

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.

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).

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. 

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. 

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?

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. 

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! 

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.)

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

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?

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

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 ?

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?

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.

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.

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....

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 .

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. 

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.

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!!

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....

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.