Myths - 401(k) Loans
Some financial advisors tell people that you should not take out a 401(k) loan due to double taxation on the loan. I agree that taking out a 401(k) loan is not a great idea because of the risk of being required to instantly repay the loan if you lose or quit your job. And, if you default on your loan, the loan will be considered a withdrawal from your 401(k) plan which will trigger a 10 percent pre-payment tax (if the default occurs before the age of 59&1/2), in addition to the regular income taxes. However, there is no double taxation on the amount of the 401(k) loan.
To see that there is no double taxation on a 401(k) loan amount itself, let us look at the loan as two streams of payments.
In the first stream of payment, the money that you contributed to the 401(k) plan was pre-tax money (tax deferred). Thus, when you take a distribution in retirement, the money distributed along with any investment gains and interest earned will be taxed. Taking out a loan does not change the tax consequences.
In the second stream of payment, the 401(k) loan payment and repayment is similar to other non-home mortgage loans. The money that you receive at the beginning of the loan is not taxed in either situation. The money that you pay back (either to the bank or to your 401(k) plan) is with after-tax money. So, there is no difference in your taxes whether the loan is from a bank or from your 401(k) plan.
Someone may say that double taxation occurs because the money you paid back for the loan is after-tax money and when it comes out of the plan at retirement, it will be taxed again. The key is all loans are paid back with after-tax money (with some exception for tax advantages on a home mortgage loan). In addition, the money from a 401(k) loan is pre-tax. Tax will need to be paid on this at some point. Instead of paying taxes on it at the time you take the loan, the IRS says the tax will still be paid at retirement or at the time you default on the loan. But, there is only one time that it is taxed. So, there is no double taxation.
For example, consider a 60-year old who earns $20,000 per year until he retires at age 65 and is taxed at a 30% tax bracket. Let's assume he contributes $20,000 to his 401(k) at age 60 and then takes a loan at age 61 of $5000 at 5% interest which he repays the following year. Here are the numbers:
The only difference not shown above, is with the loan, the person received $5,000 in year 2 that he did not have to pay taxes on. In year 3, he repays the $5,000 loan with interest (or $5,250) with his $14,000 take home pay. Yet, at age 65, the tax paid in both scenarios is exactly the same.
If we take it one step further and assume the 401(k) plan earned 5% annually (due to being invested in bonds), the 401(k) balance would be $25,525 in both cases. And, if he withdraws the whole amount at age 65, the tax would be $7,658 in both cases (30% of $25,525). So where is this additional tax that was supposed to be paid?
If there was a double tax on the principle (or 30% fee for taking out a loan on the entire balance), then 401(k) loans would definitely be the wrong idea. Yet, if you have taken a 401(k) loan and repaid it back already, do not worry, you were not doubled taxed on your loan principal.
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