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.