It has long been an urban myth that when you take out a loan from your 401k that you’re being double-taxed on the amount of your loan… but this isn’t so. This is a very pervasive myth – lots of folks will agree with it out of hand, but it’s not correct, when you work out the details. Let’s start with an explanation of why people believe that they’re being double taxed.
Double-Tax Scenario
You take out a loan from your 401k for $10,000. You make arrangements to pay this back in 10 monthly payments of $1,010, with the extra $10 representing the interest on the loan (the rate isn’t important to this example). As you pay this money back into the account, the payments are made with after-tax dollars. Fast forward to your retirement – you’re ready to start taking distributions from your 401k. All of those payments that you receive from your 401k will be taxed as ordinary income, including the $10,000 that you took out as a loan. Double-taxation, right?
Photo credit: jb
Wrong. To borrow a phrase, here’s what happened:
The Real Story
You take out a loan from your 401k for $10,000. You use that money to buy something… let’s say it’s bubble gum. Normally when you buy bubble gum, you have to buy it with after-tax dollars. The 401k loan proceeds are not taxed when you take them out, but the dollars you’re paying it back with have been taxed. This is the same as if you had bought the bubble gum with your own money from your earnings, because that money is taxed when you earn it. So when you pay the money back into the account with after-tax dollars, you’re economically the same as if you had paid it with your after-tax savings.
Maybe the following examples will help… the assumed tax rate is 20% for simplicity.
No loan. You want to buy $10,000 worth of bubble gum. You must earn $12,500 in from your job in order to have $10,000 in take-home, or after-tax, money for the purchase. So, income tax included, it has cost you $12,500 to purchase the gum.
With a loan from the bank. You want to buy $10,000 worth of bubble gum. You take out a loan from the bank for $10,000 and make arrangements to pay it back in 10 installments of $1,010 per month. As you pay back the loan, you must earn gross income of $1,262.50 (at 20% tax) to make the $1,010 payments. In the end, it has cost you $12,625, tax and interest included, to purchase the gum.
With a loan from your 401k. You want to buy $10,000 worth of bubble gum. You take out a loan from your 401k for $10,000 and make arrangements to pay it back in 10 installments of $1,010 per month. As you pay back the loan, you must earn gross income of $1,262.50 (at 20% tax) to make the $1,010 payments. In the end, it has cost you $12,625, tax and interest included, to purchase the gum, just the same cost as the bank loan. However, since you’re paying yourself the interest, your 401k account will have grown by $100 (the interest payments) with this activity.
End Result
So the end result is that you’re only taxed on your 401k funds upon distribution. If you don’t stop and think about how your money is treated for all other purposes, it might seem like an unfair situation – but economically, you’re no worse off with this loan versus any other loan (actually a bit better since you receive the interest in your 401k). And the interest is the only difference between taking this loan and just paying for it out of your regular take-home pay.
One last thing: When you took the loan from your 401k, that $10,000 was no longer invested in your account, right? Well, it may not show up in your balance, but in effect, you have invested that money in a loan to yourself. After you’ve paid back the loan and the interest, you’ll have growth of that original $10,000 to a total of $10,100 (10x the $1,010 loan payments).
Note: the foregoing explanation was not intended to be an endorsement of using a 401k loan. There can be detrimental consequences if you are unable to pay it back, or if you lose your job – in either case you’ll be taxed and penalized on the amount of the loan. You’re always best off to use all other sources of credit – and then count backwards from a million – before going ahead and taking a loan from your 401k.
Sterling Raskie, MSFS, CFP®, ChFC®
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And if you’ve come here to learn about queuing waterfowl, I apologize for the confusion. You may want to discuss your question with Lester, my loyal watchduck and self-proclaimed “advisor’s advisor”.
the problem is if you don’t buy the gum now, and wait until your 401k is mature, you pay 10000 only.
but if you need to buy it now like you said, and you spend the after tax dollar money to do it, then it cost 125000 without loan then.
Using a taxable distribution would certainly cause tax to be paid on the distribution (versus a loan). Not sure what you mean by “401k is mature” – no matter the timing, your distribution from the 401k is still taxable. If you take it before age 59.5 there’d be an additional 10% penalty, but that’s the only difference.
Maybe your comments have been corrected by now? It is a fairly dated article. Under the heading “End Result”, after having just demonstrated with your bubble gum example that a 401k loan receives the same tax treatment as a normal loan, you conclude that the only time you’re taxed is when a distribution is taken. Huh? When you take the distribution, yes, it would be taxed at that point, however, it would be for the second time, as you have clearly shown.
Yes, it is fairly dated, but the concept still is true. There is only one point of taxation of your dollars (whether or not you take out a loan from the 401k) and that is at distribution. Otherwise, the taxation that occurs to the dollars you’re repaying on the loan is the same as the taxation on any other loan payments you might make. There is no double taxation.
WAIt So I pay the loan off with after tax money (Taxed 1) Then I retire and take all that money out including the taxed money I paid the loan off with and get Taxed 2nd time on the taxed payback money? How is that not taxed 2 times?
That’s how it seems, but as explained in the article, you’ve not actually paid more in tax with a 401k loan than if you had gotten a loan from a bank.
In the last scenario (the 401k loan), isn’t your 401k balance $100 higher at the end because the interest you paid went into your account rather than to the bank? So, there *is* “difference between the two loan options, economically speaking.”
Also, if your asset allocation is X% stocks / Y% bonds / Z% cash, if you account for the loan as cash or bonds (whichever is more appropriate depending on the loan interest rate), you don’t miss out on stock gains.
There are reasons that 401k loans can be detrimental, which are the same reasons as taking out any loan, but if you HAVE to take out a loan you can pay yourself the interest rather than the bank. The analyses presented against the loans usually have these kinds of errors.
I do address the received interest at the bottom of the article. But I’ve cleaned up the wording to make it more clear, as you’re right, there is a difference, economically speaking, between the 401k loan and the bank loan.
Thanks for reaching out.
Point well made, however the real cost of a 401K loan is actually much worse than the fictional double taxation. At least it was in the plan I helped manage. If our employees took out a loan they were not eligible to contribute to the plan until the loan was paid in full. That meant they missed out on a 3% match and also lost the ability to add to the account. Since many would take out a new loan as soon as they paid off a previous loan it meant their account stayed small because they were never eligible to contribute. I was both fearful for their future and incredulous that people would take out loans to buy depreciating assets like vehicles with money they’d sorely miss upon retirement.
Yikes. Yes, that’s a definite downside to 401k loans.
That’s not double-taxation, though. It’s terrible plan rules.
Clear explanation, Jim. Thanks.
But why bubble gum?
Why not? It’s a fairly innocuous consumable. :-)