Author Topic: 401K loans  (Read 6598 times)

Smulder

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401K loans
« on: March 10, 2017, 09:35:37 PM »
I know the overwhelming advise is strongly against 401K loans but I am debating taking one out to pay back a high interest unsecured medical loan. The loan is about $25K at 8.74%. I can take out a loan to cover it and pay back myself interest at 5% in 26 bi-weekly payments over 1 year. I realize I am taxed twice on the 401K loan since I would be paying it back with post tax dollars and taxed again when I pull it out at retirement. It still seems like it is the amount of double taxation is negligible compared with the interest savings of the loan. Even the compounding interest I would receive in the 1 year period that the full amount would not be in the 401K account at current rates of return added to the duel taxation does not add up to the real savings of having the medical loan paid off. The medical loan is the only debt we have right now and I would really like to be completely debt free. I would have the ability to pay back the loan within 30 days if I changed/lost my job. I am fairly new to the mustachian world. Can I get some advise from some more seasoned FI people please?

Thank you in advance!

SwordGuy

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Re: 401K loans
« Reply #1 on: March 10, 2017, 09:56:07 PM »
Rounding a bit, the 8.74% rate would cost you about $1200 over the course of the year.  The 5% rate would be about $660.    Savings of about $540.  I assumed monthly compounding.  Assumed monthly payments at the 8.74% rate.

% likelihood of losing your job?
$ cost to pay off loan immediately? 

Why get the loan if you could just pay for it anyway?





VoteCthulu

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Re: 401K loans
« Reply #2 on: March 10, 2017, 10:21:46 PM »
Many 401k plans also charge you $20-200 to initiate the loan, and some charge an annual maintenance fee as well.

I personally don't think the risk would be worth a chance for a few hundred dollars (if whatever it was invested in stays relatively flat), but it's up to your risk tolerance.

Smulder

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Re: 401K loans
« Reply #3 on: March 10, 2017, 10:25:26 PM »
I could pay the loan off now but it would require pulling from my other investment accounts and the automatic payback wouldn't be in place. I'd like to believe that I'd be responsible enough to repay myself in the same timeframe but I'm just starting my mustachian journey and I don't trust myself that much just yet. Also, it's a bit more complicated to pull from my investment account because of a minimum balance requirement and it has been consistently outperforming my 401K in rate of return.

My 401K plan charges $35 set up fee and $12 annually. So for the life of the loan the costs would be $47

Systems101

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Re: 401K loans
« Reply #4 on: March 10, 2017, 10:53:51 PM »
I've never understood the double taxation claim made in many articles because the cash flows simply don't bear that out.  While the money put into the 401(k) originally was pre-tax, the actual cash you get loaned out of the 401(k) is effectively post tax (because it doesn't trigger tax at that point) and you pay back in post tax.  That isn't triggering any extra taxation at all.  Maybe you could assert the interest is double taxed, but even that is a tenuous claim, since there would be post tax interest paid to the original loan anyway... There are many reasons not to do a 401(k) loan, but double taxation isn't anywhere near the biggest concern.

Let's look at cash flows:

As @VoteCthulu points out, there is an initial fee.  So on "day 0":

Pay Fee ($47) - immediate cost
Get $25K from 401(k) - gives you $25K cash (effectively "post tax" cash, since it is not taxed on this exit from the 401(k) - you get the full $25K)

Over the next year, you pay back the 401(k) loan.  The 5% accrues to YOU.  Therefore (using @SwordGuy's numbers):

$25660 has been paid into the 401(k) by the end of the year.
$25660 + $x is in the 401(k) at the end of the year.  $x represents the investment gain on the funds as they get put back into the 401(k)
$y is your missed opportunity cost from not having the $25K there all year.

Your overall cost is thus:
What you could have received in 401(k) (minus) What you did receive in 401(k) (plus) actual fees (minus) reduced payments to someone else
or
$y - ($x + $660) + $47 - $1200

We can't predict x and y, you would have to model it based upon an assumed return for the year.  This opportunity cost is usually the biggest reason to avoid a 401(k) loan... it can be a huge drag on 401(k) value if there is good market return.

If you look at it another way, for the cost of the loan ($47), you can "guarantee" yourself 8.74% return on that money.  5% of that accrues into your 401(k) [the paid interest], 3.74% accrues outside the 401(k) [reduced interest expense].  There are some years where this would be a great deal, and many, many years where it would be a horrible deal. 

The bigger questions IMHO come around taking an unsecured loan and converting that into a loan from your 401(k).... you're effectively increasing the risk on the loan.

IMHO the big points to consider are:
- Converting loan from unsecured to secured by 401(k)
- Demand risk on loan if job is lost
- Financial benefit/risk (as shown above)


seattlecyclone

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Re: 401K loans
« Reply #5 on: March 11, 2017, 05:32:15 PM »
Yeah, these loans aren't "double taxation."

There are two sides to the transaction: the borrower and the lender.

As a borrower, if you borrowed from anyone else, of course you would repay the loan with post-tax funds. It's no different when you borrow from your 401(k).

As a lender, if you lent money out of your retirement account to anyone else, of course you would expect to pay tax on the interest once you pull it out of the account. It's no different when your retirement account happens to lend to yourself.

A 401(k) loan isn't "double taxation" any more than the third-party versions of both sides of this transaction would be.

Tabaxus

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Re: 401K loans
« Reply #6 on: March 11, 2017, 05:53:00 PM »
I will never understand why people don't think 401(k) loans are a really good deal in lieu of any other loan you would ever have at a higher interest rate.  You're paying the interest to yourself, so it's flatly wrong to think only in terms of "net" savings by comparing the interest rates.  If you're going to think of it in terms of net, the only thing appropriate to net out is origination fees and loan maintenance.  It doesn't make sense to take out a 401(k) loan if you would otherwise be investing the interest amount, because you could be investing post-tax dollars into assets that will generate capital gain (as opposed to OI when you eventually pull the interest out of the 401(k)), but if the choices are high-interest consumer debt vs a 401(k) loan, and you have a high level of security in your job, I don't see how this isn't the right move.

Yes, there is always a real possibility that you lose out on market gains while you have your money out of the market, but the OP is talking about an 8.74% loan.  It makes absolutely no sense at all to bet that the market will beat 8.74%. 
« Last Edit: March 11, 2017, 05:54:36 PM by Tabaxus »

MrFrugalChicago

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Re: 401K loans
« Reply #7 on: March 11, 2017, 06:04:50 PM »
I will never understand why people don't think 401(k) loans are a really good deal in lieu of any other loan you would ever have at a higher interest rate.  You're paying the interest to yourself, so it's flatly wrong to think only in terms of "net" savings by comparing the interest rates.  If you're going to think of it in terms of net, the only thing appropriate to net out is origination fees and loan maintenance.  It doesn't make sense to take out a 401(k) loan if you would otherwise be investing the interest amount, because you could be investing post-tax dollars into assets that will generate capital gain (as opposed to OI when you eventually pull the interest out of the 401(k)), but if the choices are high-interest consumer debt vs a 401(k) loan, and you have a high level of security in your job, I don't see how this isn't the right move.

Yes, there is always a real possibility that you lose out on market gains while you have your money out of the market, but the OP is talking about an 8.74% loan.  It makes absolutely no sense at all to bet that the market will beat 8.74%.

The risk is you lose your job. Then you need to pay it back pronto or face large tax penalties. Trust me, the day you want someone showing up and demanding a 25k payment is NOT the day you lost your job.

Tabaxus

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Re: 401K loans
« Reply #8 on: March 11, 2017, 06:07:20 PM »
I will never understand why people don't think 401(k) loans are a really good deal in lieu of any other loan you would ever have at a higher interest rate.  You're paying the interest to yourself, so it's flatly wrong to think only in terms of "net" savings by comparing the interest rates.  If you're going to think of it in terms of net, the only thing appropriate to net out is origination fees and loan maintenance.  It doesn't make sense to take out a 401(k) loan if you would otherwise be investing the interest amount, because you could be investing post-tax dollars into assets that will generate capital gain (as opposed to OI when you eventually pull the interest out of the 401(k)), but if the choices are high-interest consumer debt vs a 401(k) loan, and you have a high level of security in your job, I don't see how this isn't the right move.

Yes, there is always a real possibility that you lose out on market gains while you have your money out of the market, but the OP is talking about an 8.74% loan.  It makes absolutely no sense at all to bet that the market will beat 8.74%.

The risk is you lose your job. Then you need to pay it back pronto or face large tax penalties. Trust me, the day you want someone showing up and demanding a 25k payment is NOT the day you lost your job.

Sure.  These make no sense for someone without a high level of job security over the anticipated repayment period.  Readily agree there.

Hotstreak

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Re: 401K loans
« Reply #9 on: March 11, 2017, 07:02:45 PM »
I will never understand why people don't think 401(k) loans are a really good deal in lieu of any other loan you would ever have at a higher interest rate.  You're paying the interest to yourself, so it's flatly wrong to think only in terms of "net" savings by comparing the interest rates.  If you're going to think of it in terms of net, the only thing appropriate to net out is origination fees and loan maintenance.  It doesn't make sense to take out a 401(k) loan if you would otherwise be investing the interest amount, because you could be investing post-tax dollars into assets that will generate capital gain (as opposed to OI when you eventually pull the interest out of the 401(k)), but if the choices are high-interest consumer debt vs a 401(k) loan, and you have a high level of security in your job, I don't see how this isn't the right move.

Yes, there is always a real possibility that you lose out on market gains while you have your money out of the market, but the OP is talking about an 8.74% loan.  It makes absolutely no sense at all to bet that the market will beat 8.74%.

The risk is you lose your job. Then you need to pay it back pronto or face large tax penalties. Trust me, the day you want someone showing up and demanding a 25k payment is NOT the day you lost your job.

Sure.  These make no sense for someone without a high level of job security over the anticipated repayment period.  Readily agree there.


OP said they can pay it back within 30 days, since they have access to other investments.

intellectsucks

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Re: 401K loans
« Reply #10 on: March 11, 2017, 08:23:52 PM »
Have you looked into getting $25k in credit card balance transfer offers? Unless you have some fucked up credit issues, it shouldn't be too hard to wrangle up.

Bateaux

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Re: 401K loans
« Reply #11 on: March 11, 2017, 09:00:06 PM »
Leave it alone.  Pay the loan off as quick as possible.  Fine a side gig if you must.  Leave the 401k alone.

PizzaSteve

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Re: 401K loans
« Reply #12 on: March 12, 2017, 10:21:09 AM »
I would do it.  I see no problem with 401k loan as long as you are doing it because you want to kill the high interest loan and truely have other money, but do not want to trigger capital gains by selling taxible other investments.  This assumes you still have the other investments/fund sources for an emergency payoff. 

Go ahead an do it in your situation, unless it is enabling too much spending and consumption.
« Last Edit: March 12, 2017, 10:23:04 AM by PizzaSteve »

Ocinfo

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401K loans
« Reply #13 on: March 12, 2017, 10:29:02 AM »
I'm usually opposed because people use them for stupid things or lower interest debt. In your case, you're basically issuing a bond in yourself to avoid paying taxes on gains (no different than what Apple does since most cash is outside the USA). Another, lower risk option, is getting a credit card from Citi or BoA with a 0% for 18 months offer. Might have to pay 4% up front or not depending on your options for paying your loan. I did this a few years back and ultimately saved $1,500 in interest. Or, lastly, just pay what you would pay on the 401k loan onto the medical loan and you'll only pay a fraction of the money interest.


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MrMoneySaver

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Re: 401K loans
« Reply #14 on: March 12, 2017, 10:49:06 AM »
I've done 401k loans a couple of times and they're pretty handy. The second time, I ended up leaving the job before it was paid off, and ended up having to scramble to pay it back. It was a little painful, but it still worked out OK.

Proud Foot

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Re: 401K loans
« Reply #15 on: March 13, 2017, 10:25:28 AM »
Yeah, these loans aren't "double taxation."

There are two sides to the transaction: the borrower and the lender.

As a borrower, if you borrowed from anyone else, of course you would repay the loan with post-tax funds. It's no different when you borrow from your 401(k).

As a lender, if you lent money out of your retirement account to anyone else, of course you would expect to pay tax on the interest once you pull it out of the account. It's no different when your retirement account happens to lend to yourself.

A 401(k) loan isn't "double taxation" any more than the third-party versions of both sides of this transaction would be.

While your examples are correct, when you are the borrower and lender then the interest portion would be double taxed.  You're paying the interest with after tax dollars and then paying tax again when you take a distribution from the 401k.  I wouldn't place much emphasis on this when determining whether to do a 401k loan or not as the interest most likely will be a small amount. I have always considered a 401k loan to be an absolute last resort.

NoStacheOhio

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Re: 401K loans
« Reply #16 on: March 13, 2017, 11:39:07 AM »
I'm usually opposed because people use them for stupid things or lower interest debt. In your case, you're basically issuing a bond in yourself to avoid paying taxes on gains (no different than what Apple does since most cash is outside the USA). Another, lower risk option, is getting a credit card from Citi or BoA with a 0% for 18 months offer. Might have to pay 4% up front or not depending on your options for paying your loan. I did this a few years back and ultimately saved $1,500 in interest. Or, lastly, just pay what you would pay on the 401k loan onto the medical loan and you'll only pay a fraction of the money interest.


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In most cases, it wouldn't be a balance transfer. OP could call up the loan servicer and make a credit card payment in full. They might charge a credit card fee, but if they do, it'll probably be less than 4%.

financepatriot@gmail.com

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Re: 401K loans
« Reply #17 on: March 13, 2017, 03:08:54 PM »
I would look to cut further back on expenses first, and pay that loan off as early as possible.  I would only use the 401k loan as a last option.  Challenge yourself to cut your expenses down.  Go Ramen if you have to, this is only temporary.  I am not joking. 

Smulder

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Re: 401K loans
« Reply #18 on: March 21, 2017, 12:56:31 PM »
Update...I did go ahead with the 401K loan. I am excited that we literally have no debt and, to me, that feeling is worth the potential downside of taking the 401K loan. Thank you for all of your advise. I appreciate the responses I received and even though made a decision not inline with some of you I still believe everyone had valid points and I took them all into consideration in making my decision. You guys are awesome!!!

BlueHouse

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Re: 401K loans
« Reply #19 on: March 21, 2017, 01:48:37 PM »
I've never understood the double taxation claim made in many articles because the cash flows simply don't bear that out.  While the money put into the 401(k) originally was pre-tax, the actual cash you get loaned out of the 401(k) is effectively post tax (because it doesn't trigger tax at that point) and you pay back in post tax.  That isn't triggering any extra taxation at all. 

If I'm paid $100/hour and I take out a loan for $100K, I worked 1000 hours to save that money. 
But when I repay it, assuming I'm in the 28% tax bracket, I have to work 1388 hours to repay the money. 

I don't think the issue is really double-taxation, because the hurt is captured in the extra 388 working hours. 


NoStacheOhio

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Re: 401K loans
« Reply #20 on: March 22, 2017, 06:10:16 AM »
Update...I did go ahead with the 401K loan. I am excited that we literally have no debt and, to me, that feeling is worth the potential downside of taking the 401K loan. Thank you for all of your advise. I appreciate the responses I received and even though made a decision not inline with some of you I still believe everyone had valid points and I took them all into consideration in making my decision. You guys are awesome!!!

You might want to change your thinking here, because the 401k loan is still debt. It's just money you owe yourself instead of a third party.

runewell

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Re: 401K loans
« Reply #21 on: March 22, 2017, 06:34:21 AM »
I've never understood the double taxation claim made in many articles because the cash flows simply don't bear that out.  While the money put into the 401(k) originally was pre-tax, the actual cash you get loaned out of the 401(k) is effectively post tax (because it doesn't trigger tax at that point) and you pay back in post tax.  That isn't triggering any extra taxation at all. 

If I'm paid $100/hour and I take out a loan for $100K, I worked 1000 hours to save that money. 
But when I repay it, assuming I'm in the 28% tax bracket, I have to work 1388 hours to repay the money. 

I don't think the issue is really double-taxation, because the hurt is captured in the extra 388 working hours.

But that $100K is really only $72K because you're going to have to pay taxes on it eventually. (Yes I realize the tax bracket could change in retirement but that's not the point).  You do not get $100K out of $1,000 hours of work.

Viking Thor

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Re: 401K loans
« Reply #22 on: March 22, 2017, 09:16:10 AM »
It's not double taxation.

When you use the 401k loan to pay your $25k medical debt, you are using money that has never been taxed. Then you need to use money that has been taxed to repay the 401k loan. Let's say for example you need to earn $30k gross so $5k goes to the tax man and $25k goes to paying back your 401k loan.

If you didn't take $401k loan, you would need to earn $30k gross in order to pay the tax man his $5k cut plus pay back the $25k medical loan.

So in either case you need to earn $30k gross to get the $25k medical loan paid. The only difference is paying the medical debt for a longer period of time, or instead forgoing the investment gains for the 401k while it is being repaid.


Proud Foot

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Re: 401K loans
« Reply #23 on: March 22, 2017, 09:44:52 AM »
It's not double taxation.

When you use the 401k loan to pay your $25k medical debt, you are using money that has never been taxed. Then you need to use money that has been taxed to repay the 401k loan. Let's say for example you need to earn $30k gross so $5k goes to the tax man and $25k goes to paying back your 401k loan.

If you didn't take $401k loan, you would need to earn $30k gross in order to pay the tax man his $5k cut plus pay back the $25k medical loan.

So in either case you need to earn $30k gross to get the $25k medical loan paid. The only difference is paying the medical debt for a longer period of time, or instead forgoing the investment gains for the 401k while it is being repaid.

You are forgetting about the interest though.  You are essentially taking out the principal of the loan and repaying it with with no net taxation.  However your interest it paid back with after tax money and that interest is taxed again once you start taking distributions from the account.  This is what is double taxed.

AnEDO

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Re: 401K loans
« Reply #24 on: March 22, 2017, 09:55:57 AM »
I've used 2 401k loans to buy investment properties.  Regarding the double taxation of the interest, I would still rather pay the interest to myself and pay taxes on it someday than pay the interest to another lender and never see the money again. 

nobody123

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Re: 401K loans
« Reply #25 on: March 22, 2017, 10:08:54 AM »
I like this post to explain why it's not double-taxation: https://thefinancebuff.com/401k-loan-double-taxation-myth.html

Quote
Now, back to our 401k double taxation myth. The fact that the loan has to be repaid with after-tax dollars is irrelevant, just like the $30 number in the hotel puzzle. If you didn’t borrow from the 401k plan but you borrowed from a bank, you’d have to pay the bank back with after-tax dollars as well. If you didn’t borrow from your 401k plan but you dipped into your own savings, you have to replace those savings with after-tax dollars too. What it really means is that a 401k loan is not tax deductible, just like any other consumer loan except a mortgage or a HELOC. Instead of saying you will be double taxed, they should just say that a 401k loan is not tax deductible, plain and simple.

hobbes1

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Re: 401K loans
« Reply #26 on: March 22, 2017, 10:15:39 AM »
We have been considering this (403b loan) for something and it's an attractive alternative.
The beauty of the loan is that, at least with my employer's 403b setup (with Fidelity), if you separate service for any reason from your job, you can either: A) continue to pay back the loan under the original terms B) pay off the loan in one lump sump assuming you had that money to pay it back like that or C) not pay it back at all (and it would then be taxed as income).

So, for the OP, there is a high interest loan hanging over his head and by using the 401k to pay that off, he has removed the absolute need to pay off the debt if he experienced unexpected job loss. I'd bet that whoever owned the medical loan he was paying back, would not let him off the hook like a loan from his own self would, if needed.


coppertop

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Re: 401K loans
« Reply #27 on: March 22, 2017, 10:26:27 AM »
Not only would it be taxed as income, but I believe there would also be a penalty.  Someone with more knowledge may correct me on that ... to me, it's a slippery slope to think of retirement savings as a piggy bank that one can borrow from.  I would only do it in the direst of circumstances. 

Proud Foot

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Re: 401K loans
« Reply #28 on: March 22, 2017, 10:56:18 AM »
Nobody123,  that was a good article you linked. However I think you still have to agree that the interest is paid back with after tax money, and tax is paid again on that interest when taken as a distribution.  Obviously this is a generalization as it is possible to take distributions from the account and still have an effective tax rate of 0%. I think finance "gurus" stating that you will be double taxed leads people to believe they will be taxed twice on the entire amount they repay on the 401k loan.  This wouldn't be as big of a topic of discussion if they would instead say that only the interest is double taxed.

Regarding what you quoted from the article:  The bank loan: yes this is true.  Savings: your own savings would already be built up with after tax money and is not really relevant to the discussion on 401k loans and double taxation as you are not taxed again on what you put in savings.

In the article there is the diagram followed by this paragraph:
Quote
The left hand side represents a typical consumer loan, like a car loan. The arrows represent “borrows from” and “pays back to.” You borrow from a bank. The bank borrows from the financial market. Your 401k invests in the financial market. I think we all agree there is no double taxation in this case. You pay after-tax dollars to the bank for both principal and interest. Your 401k earns from the financial market but the earnings have to be taxed when you withdraw from your 401k.
To me, the difference is that the interest leaves your control when borrowing from the bank whereas the interest is still under your control when paying back the 401k loan.

nobody123

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Re: 401K loans
« Reply #29 on: March 22, 2017, 03:41:30 PM »
Nobody123,  that was a good article you linked. However I think you still have to agree that the interest is paid back with after tax money, and tax is paid again on that interest when taken as a distribution.  Obviously this is a generalization as it is possible to take distributions from the account and still have an effective tax rate of 0%. I think finance "gurus" stating that you will be double taxed leads people to believe they will be taxed twice on the entire amount they repay on the 401k loan.  This wouldn't be as big of a topic of discussion if they would instead say that only the interest is double taxed.

Regarding what you quoted from the article:  The bank loan: yes this is true.  Savings: your own savings would already be built up with after tax money and is not really relevant to the discussion on 401k loans and double taxation as you are not taxed again on what you put in savings.

In the article there is the diagram followed by this paragraph:
Quote
The left hand side represents a typical consumer loan, like a car loan. The arrows represent “borrows from” and “pays back to.” You borrow from a bank. The bank borrows from the financial market. Your 401k invests in the financial market. I think we all agree there is no double taxation in this case. You pay after-tax dollars to the bank for both principal and interest. Your 401k earns from the financial market but the earnings have to be taxed when you withdraw from your 401k.
To me, the difference is that the interest leaves your control when borrowing from the bank whereas the interest is still under your control when paying back the 401k loan.

I like to think of it this way:  If I take a 401k loan for $25K @5%, my 401k is just changing its investments like it bought a 5% bond that Nobody123 issued.  The 401k gets the proceeds of this investment, and the ~$26K that Nobody123 put back over the course of a year to pay off the bond (loan) goes back in tax-deferred like any other investment the 401k could have chosen.  What Nobody123 personally did with the cash or how much Nobody123 had to pay to the IRS to net the ~$26K to pay the bond (loan) back is totally irrelevant from the 401k's point of view.  Essentially, the 401k used some of its assets to purchase a return-generating investment, so from the 401k's point of view, no taxable event occurred.  Therefore the money is taxed only once, upon its ultimate withdrawal from the 401k.

I don't get what you're trying to say regarding "control" of the interest.  As soon as you decide to take a loan out (a mortgage being the exception), you're using after-tax funds to pay it back, regardless of what institution is lending you the money.  Just because you sold a bond to your 401k instead of borrowing from a bank doesn't change that fact.  If you decide the total cost of a 401k loan is better than your other borrowing alternatives, so be it, but it doesn't mean you're exposing the interest to double-taxation.

Viking Thor

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Re: 401K loans
« Reply #30 on: March 22, 2017, 08:56:32 PM »
It's not double taxation.

When you use the 401k loan to pay your $25k medical debt, you are using money that has never been taxed. Then you need to use money that has been taxed to repay the 401k loan. Let's say for example you need to earn $30k gross so $5k goes to the tax man and $25k goes to paying back your 401k loan.

If you didn't take $401k loan, you would need to earn $30k gross in order to pay the tax man his $5k cut plus pay back the $25k medical loan.

So in either case you need to earn $30k gross to get the $25k medical loan paid. The only difference is paying the medical debt for a longer period of time, or instead forgoing the investment gains for the 401k while it is being repaid.

You are forgetting about the interest though.  You are essentially taking out the principal of the loan and repaying it with with no net taxation.  However your interest it paid back with after tax money and that interest is taxed again once you start taking distributions from the account.  This is what is double taxed.
The interest is not double taxed either, the same example I gave also applies to the interest. If you didn't take 401k loan, you would be paying the medical loan interest with after tax dollars (meaning you had to earn morethan the medical loan interest, to also pay the tax). I could give the exact same example as above my original post but applied to interest.

Need2Save

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Re: 401K loans
« Reply #31 on: March 23, 2017, 06:37:26 AM »
Not only would it be taxed as income, but I believe there would also be a penalty.  Someone with more knowledge may correct me on that ... to me, it's a slippery slope to think of retirement savings as a piggy bank that one can borrow from.  I would only do it in the direst of circumstances.

The penalty is an extra 10% unless you are over the age of 59.5.  Otherwise, it's just treated as a taxable distribution in the year the 401k loan defaults.  Different plans will have different rules on when the loan is considered defaulted.  Some are 30-60 days, and some are in the quarter following your termination.

Even some of the most confident/secure jobs can experience issues with 401k loans if the company is sold or merged with another company.  This would probably be less likely an issue if you work for a government or public service kind of job.  However, in private industry - you rarely know what is being discussed. 401k loans can be a convenient alternative, but I always cringe when I see someone take up to the limit of $50,000.  That would be a lot of money to try to come up with if you had to pay it off quickly to avoid immediate taxation (with penalty to boot). 

NoStacheOhio

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Re: 401K loans
« Reply #32 on: March 23, 2017, 06:37:31 AM »
Not only would it be taxed as income, but I believe there would also be a penalty.  Someone with more knowledge may correct me on that ... to me, it's a slippery slope to think of retirement savings as a piggy bank that one can borrow from.  I would only do it in the direst of circumstances.

Correct. Regular income tax plus 10% on any amounts not repaid.

runewell

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Re: 401K loans
« Reply #33 on: March 23, 2017, 07:55:58 AM »
It's not double taxation.

When you use the 401k loan to pay your $25k medical debt, you are using money that has never been taxed. Then you need to use money that has been taxed to repay the 401k loan. Let's say for example you need to earn $30k gross so $5k goes to the tax man and $25k goes to paying back your 401k loan.

If you didn't take $401k loan, you would need to earn $30k gross in order to pay the tax man his $5k cut plus pay back the $25k medical loan.

So in either case you need to earn $30k gross to get the $25k medical loan paid. The only difference is paying the medical debt for a longer period of time, or instead forgoing the investment gains for the 401k while it is being repaid.

You are forgetting about the interest though.  You are essentially taking out the principal of the loan and repaying it with with no net taxation.  However your interest it paid back with after tax money and that interest is taxed again once you start taking distributions from the account.  This is what is double taxed.
The interest is not double taxed either, the same example I gave also applies to the interest. If you didn't take 401k loan, you would be paying the medical loan interest with after tax dollars (meaning you had to earn morethan the medical loan interest, to also pay the tax). I could give the exact same example as above my original post but applied to interest.

Correct on all accounts!

frugalnacho

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Re: 401K loans
« Reply #34 on: March 24, 2017, 08:06:09 AM »
It's not double taxation.

When you use the 401k loan to pay your $25k medical debt, you are using money that has never been taxed. Then you need to use money that has been taxed to repay the 401k loan. Let's say for example you need to earn $30k gross so $5k goes to the tax man and $25k goes to paying back your 401k loan.

If you didn't take $401k loan, you would need to earn $30k gross in order to pay the tax man his $5k cut plus pay back the $25k medical loan.

So in either case you need to earn $30k gross to get the $25k medical loan paid. The only difference is paying the medical debt for a longer period of time, or instead forgoing the investment gains for the 401k while it is being repaid.

You are forgetting about the interest though.  You are essentially taking out the principal of the loan and repaying it with with no net taxation.  However your interest it paid back with after tax money and that interest is taxed again once you start taking distributions from the account.  This is what is double taxed.
The interest is not double taxed either, the same example I gave also applies to the interest. If you didn't take 401k loan, you would be paying the medical loan interest with after tax dollars (meaning you had to earn morethan the medical loan interest, to also pay the tax). I could give the exact same example as above my original post but applied to interest.

Correct on all accounts!

But what if you don't have a medical loan?  What if I just take a 401k loan out because I want to have a giant pile of cash in my living room? 



The 401k-loan-double-taxation myth is a pet peeve of mine and I was going to respond, but others have thoroughly debunked it already.  You are totally double taxed on the interest though.  Your overall increase in taxes may be less than the interest you pay on a different loan, but that doesn't mean you aren't double taxed on that portion of the loan, it just means you paid less in taxes than you did in interest to a third party loan.  If I just take a 401k loan out to roll around in a pile of cash scrooge mcduck style and make my regular payments back to my 401k (@ 5% interest), then that interest portion is double taxed.  It's taxed this year when I earn it, and it's taxed again when it comes out of my 401k.

nobody123

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Re: 401K loans
« Reply #35 on: March 24, 2017, 10:07:07 AM »
<snip>

If I just take a 401k loan out to roll around in a pile of cash scrooge mcduck style and make my regular payments back to my 401k (@ 5% interest), then that interest portion is double taxed.  It's taxed this year when I earn it, and it's taxed again when it comes out of my 401k.

No it isn't.  The 401k didn't pay tax on the interest you paid to it, it is deferred until you decide to have the 401k pay it out to you.  The earnings the 401k had on the investment (the loan) are only taxed once.  If you sold your car to raise the funds to pay back the loan, or your grandma wrote you a check for the interest amount, instead of taking cash from your paycheck, would you claim the interest was double-taxed?  The fact that your paycheck income is taxed today and the fact that future you will be taxed on the 401k withdrawal are two separate things.

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Re: 401K loans
« Reply #36 on: March 24, 2017, 10:55:47 AM »
<snip>

If I just take a 401k loan out to roll around in a pile of cash scrooge mcduck style and make my regular payments back to my 401k (@ 5% interest), then that interest portion is double taxed.  It's taxed this year when I earn it, and it's taxed again when it comes out of my 401k.

No it isn't.  The 401k didn't pay tax on the interest you paid to it, it is deferred until you decide to have the 401k pay it out to you.  The earnings the 401k had on the investment (the loan) are only taxed once.  If you sold your car to raise the funds to pay back the loan, or your grandma wrote you a check for the interest amount, instead of taking cash from your paycheck, would you claim the interest was double-taxed? The fact that your paycheck income is taxed today and the fact that future you will be taxed on the 401k withdrawal are two separate things.

This is where the double taxation comes in.  No, you are not double taxed on the interest in the same year but the fact still remains that the interest is paid back with after tax money today and then is still taxed when you take the 401k withdrawal.

Quote
I don't get what you're trying to say regarding "control" of the interest.  As soon as you decide to take a loan out (a mortgage being the exception), you're using after-tax funds to pay it back, regardless of what institution is lending you the money.  Just because you sold a bond to your 401k instead of borrowing from a bank doesn't change that fact.  If you decide the total cost of a 401k loan is better than your other borrowing alternatives, so be it, but it doesn't mean you're exposing the interest to double-taxation.

To clarify, when you pay back interest to a bank then the interest is no longer yours.  The bank has control (ownership) of that interest money but when you pay back the interest on a 401k loan you are moving the interest from one bucket to another, both of which are under your control (ownership).  You are also moving your money from a post tax bucket to a pretax bucket where you will be taxed when you take a distribution from it.  Your statements are more focused on the money today and do not seem to also consider the future date when you take distributions from the 401k. The double taxation does not take place during the time period of the loan but in the future.

frugalnacho

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Re: 401K loans
« Reply #37 on: March 24, 2017, 11:09:52 AM »
<snip>

If I just take a 401k loan out to roll around in a pile of cash scrooge mcduck style and make my regular payments back to my 401k (@ 5% interest), then that interest portion is double taxed.  It's taxed this year when I earn it, and it's taxed again when it comes out of my 401k.

No it isn't.  The 401k didn't pay tax on the interest you paid to it, it is deferred until you decide to have the 401k pay it out to you.  The earnings the 401k had on the investment (the loan) are only taxed once.  If you sold your car to raise the funds to pay back the loan, or your grandma wrote you a check for the interest amount, instead of taking cash from your paycheck, would you claim the interest was double-taxed?  The fact that your paycheck income is taxed today and the fact that future you will be taxed on the 401k withdrawal are two separate things.

Yes I would.  The 401k didn't pay tax on the interest, but I did.  The principal of the loan was never taxed, but that interest is.  If I borrowed $100 from my 401k, and pay back $105, then that $5 portion is double taxed because that $5 is included on my income for this year*.  It will also be included as income in the year I eventually withdraw it. 

*Or whatever year I earned it. 

The same is true if the money comes from selling an asset (I paid my taxes on my income before I was able to purchase that asset in the first place), or being gifted money from grandma (grandma would have paid taxes on the $5 she gave me).

Say the loan % was something outrageous, like a hundred trillion % or some other ungodly number.  You borrow $100 from your 401k, but now you have to pay back a trillion dollars to square up your account.  You have to somehow earn that trillion dollars and pay taxes on it, before you can put it into your 401k, and you get no special tax treatment for putting that "interest" money into the account.  When you eventually withdraw that trillion dollars in the future you are also paying taxes on it. 

seattlecyclone

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Re: 401K loans
« Reply #38 on: March 24, 2017, 11:43:48 AM »
Consider two scenarios:

Scenario A:
You borrow money at 5% interest from a bank. You repay the loan with post-tax dollars.
You buy a bond earning 5% in your 401(k). You pay tax on the full amount (principal and interest) when you withdraw money from your 401(k).

Scenario B:
You borrow money at 5% interest from your 401(k). You repay the loan with post-tax dollars.
You lend money at 5% interest from your 401(k). You pay tax on the full amount (principal and interest) when you withdraw the money from your 401(k).

There is no difference in the amount of tax you pay in either scenario! If scenario B is "double taxation," does that label apply to Scenario A as well?

Proud Foot

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Re: 401K loans
« Reply #39 on: March 24, 2017, 01:00:16 PM »
Consider two scenarios:

Scenario A:
You borrow money at 5% interest from a bank. You repay the loan with post-tax dollars.
You buy a bond earning 5% in your 401(k). You pay tax on the full amount (principal and interest) when you withdraw money from your 401(k).

Scenario B:
You borrow money at 5% interest from your 401(k). You repay the loan with post-tax dollars.
You lend money at 5% interest from your 401(k). You pay tax on the full amount (principal and interest) when you withdraw the money from your 401(k).

There is no difference in the amount of tax you pay in either scenario! If scenario B is "double taxation," does that label apply to Scenario A as well?

While you pay the same amount of tax the difference is how the money is transferred and who has ownership.  In scenario B the interest money is after tax and then becomes pretax upon paying back the 401k loan.  The interest is still under your ownership so you are paying income tax on the same money twice. Scenario A the interest is going to a new owner (bank) while the interest on the bond comes from a previous owner (bond issuer)

frugalnacho

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Re: 401K loans
« Reply #40 on: March 24, 2017, 01:05:01 PM »
Consider two scenarios:

Scenario A:
You borrow money at 5% interest from a bank. You repay the loan with post-tax dollars.
You buy a bond earning 5% in your 401(k). You pay tax on the full amount (principal and interest) when you withdraw money from your 401(k).

Scenario B:
You borrow money at 5% interest from your 401(k). You repay the loan with post-tax dollars.
You lend money at 5% interest from your 401(k). You pay tax on the full amount (principal and interest) when you withdraw the money from your 401(k).

There is no difference in the amount of tax you pay in either scenario! If scenario B is "double taxation," does that label apply to Scenario A as well?

Assuming the loan is $100, and paid back after 1 year just to make calculations simple...

Don't both scenarios trigger $105 in taxes at a future date?  The difference is that 5 of those dollars in scenario A come from bond interest (which you never paid taxes on), while 5 of those dollars in scenario B are from your pocket (which you already paid taxes on)?

Your examples seem overly complicated and convoluted.

Say you have $5 in cash.  You also have $100 in your 401k.  You keep your 401k in cash, so no interest or growth.  You also have earned no money this year, and never will for the rest of this example.

Scenario A:

You withdraw $100 from your 401k.  You now have $100 in taxable income.  You also have $5 in "post-tax" money that you already had.

Scenario B:

You borrow $100 from your 401k.  You pay back your loan within the same year at a cost of $105.  You withdraw $105 from your 401k.  You now have $105 in taxable income.

You have not earned or spent any money in either scenario, just shuffled the money around., but scenario B gives you a higher tax liability.  You are being double taxed on the interest you paid back into the loan.

Dicey

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Re: 401K loans
« Reply #41 on: March 24, 2017, 01:46:51 PM »
Late to this iteration of the party. Has anybody mentioned that while your money is out of the market you're missing out on any and all market gains?

How about this one: it's highly possible that you will be surprised to find yourself feeling like an indentured servant while you owe that money. Heaven forbid if a better job offer comes your way, or something happens to your job through no fault of your own. #askmehowIknow.  And never-again-even-though-I-made-a-boatload-of-money-on-the-real-estate-I-bought-with-the-loan.
« Last Edit: March 27, 2017, 07:46:22 AM by Dicey »

seattlecyclone

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Re: 401K loans
« Reply #42 on: March 24, 2017, 02:06:53 PM »
Consider two scenarios:

Scenario A:
You borrow money at 5% interest from a bank. You repay the loan with post-tax dollars.
You buy a bond earning 5% in your 401(k). You pay tax on the full amount (principal and interest) when you withdraw money from your 401(k).

Scenario B:
You borrow money at 5% interest from your 401(k). You repay the loan with post-tax dollars.
You lend money at 5% interest from your 401(k). You pay tax on the full amount (principal and interest) when you withdraw the money from your 401(k).

There is no difference in the amount of tax you pay in either scenario! If scenario B is "double taxation," does that label apply to Scenario A as well?

While you pay the same amount of tax the difference is how the money is transferred and who has ownership.  In scenario B the interest money is after tax and then becomes pretax upon paying back the 401k loan.  The interest is still under your ownership so you are paying income tax on the same money twice. Scenario A the interest is going to a new owner (bank) while the interest on the bond comes from a previous owner (bond issuer)

Yep, the only difference between the scenarios is that in Scenario A you're borrowing money from a third party and your 401(k) is loaning money to a different third party, while in Scenario B your 401(k) is loaning money to you. In every other respect the transaction is identical. You get the same amount of liquid cash outside your 401(k), you pay the same interest rate on this cash, your 401(k) earns the same amount of interest, and you have the same tax-deferred balance at the end.

So by the same logic that your 401(k) loan interest is "double taxed" because you repaid the loan with post-tax dollars and you'll owe tax on the interest when it is eventually withdrawn, Scenario A is "double taxed" because you repaid the loan with post-tax dollars and the bank will owe tax on the interest. Heck, in Scenario A you also pay tax on the bond interest, and the bond issuer (if a for-profit entity) is repaying the bond with post-tax funds. Quadruple taxation?

frugalnacho

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Re: 401K loans
« Reply #43 on: March 24, 2017, 02:31:40 PM »
Consider two scenarios:

Scenario A:
You borrow money at 5% interest from a bank. You repay the loan with post-tax dollars.
You buy a bond earning 5% in your 401(k). You pay tax on the full amount (principal and interest) when you withdraw money from your 401(k).

Scenario B:
You borrow money at 5% interest from your 401(k). You repay the loan with post-tax dollars.
You lend money at 5% interest from your 401(k). You pay tax on the full amount (principal and interest) when you withdraw the money from your 401(k).

There is no difference in the amount of tax you pay in either scenario! If scenario B is "double taxation," does that label apply to Scenario A as well?

While you pay the same amount of tax the difference is how the money is transferred and who has ownership.  In scenario B the interest money is after tax and then becomes pretax upon paying back the 401k loan.  The interest is still under your ownership so you are paying income tax on the same money twice. Scenario A the interest is going to a new owner (bank) while the interest on the bond comes from a previous owner (bond issuer)

Yep, the only difference between the scenarios is that in Scenario A you're borrowing money from a third party and your 401(k) is loaning money to a different third party, while in Scenario B your 401(k) is loaning money to you. In every other respect the transaction is identical. You get the same amount of liquid cash outside your 401(k), you pay the same interest rate on this cash, your 401(k) earns the same amount of interest, and you have the same tax-deferred balance at the end.

So by the same logic that your 401(k) loan interest is "double taxed" because you repaid the loan with post-tax dollars and you'll owe tax on the interest when it is eventually withdrawn, Scenario A is "double taxed" because you repaid the loan with post-tax dollars and the bank will owe tax on the interest. Heck, in Scenario A you also pay tax on the bond interest, and the bond issuer (if a for-profit entity) is repaying the bond with post-tax funds. Quadruple taxation?

They aren't identical though.  In scenario A the bond interest is generated from within your 401k and 100% of the taxes on that portion are deferred.   In scenario B you are taking your "post-tax" money (in an amount equal to the scenario A bond interest earned) and changing it into "pre-tax" money by repaying the interest portion of the loan, but without getting any tax deferment (like you do with normal 401k contributions). 

The rest of the details seem to make the example unnecessarily complicated and confusing. 

And semantically speaking all money is infinite-taxed.  My employer paid taxes on money before he paid me.  The clients likely paid taxes on that money before they spent it with my company.  Their clients did the same, and so on.  And when I pay a mechanic to fix my car, he will also pay tax on that money.  Then he comes to my business and pays for a service, and of course my company will pay taxes on that same dollar, which they will then give to me and I'll owe taxes on it, and I'll pay my mechanic with it, and so on and so forth. 

I think the only relevant point that matters when we are talking about taxes is how much you personally owe.  The bank's business is the bank's business, same with the bond holder. 
« Last Edit: March 24, 2017, 02:33:47 PM by frugalnacho »

nobody123

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Re: 401K loans
« Reply #44 on: March 24, 2017, 02:36:55 PM »
You have to somehow earn that trillion dollars and pay taxes on it, before you can put it into your 401k, and you get no special tax treatment for putting that "interest" money into the account.  When you eventually withdraw that trillion dollars in the future you are also paying taxes on it.

EXACTLY.  I'll refer back to the article I linked to.  I think you're assuming that because you have to pay income tax on your wages to pay the interest on the loan, you're being taxed twice on the same money.  The fact that you had to pay income tax on the funds you earned to pay the interest on the loan is because the interest on that type of loan is not tax deductible.  It is unavoidable, and therefore irrelevant.  If you didn't take out a loan from your 401k and instead put your pay in your Scrooge McDuck pile, was it not all subject to taxation?  There was no way to pay zero tax on the income earned to pay the interest on the loan, so it shouldn't be viewed as subject to some sort of double-tax penalty.  You were always going to pay tax on that trillion dollars of income.  You were always going to pay tax on the 401k distribution.  Nothing changed just because you took the loan out from the 401k instead of a bank.

Just because I like to argue, what if you paid the interest back with a refundible tax credit like the EITC?  Then is the interest you paid double taxed?  Similarly, aren't YOUR tax deferred contributions to a 401k essentially double-taxed even if you never take a loan because the government had to have an offsetting income source to fund the tax deferrments in retirement plans?

seattlecyclone

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Re: 401K loans
« Reply #45 on: March 24, 2017, 02:56:25 PM »
Consider two scenarios:

Scenario A:
You borrow money at 5% interest from a bank. You repay the loan with post-tax dollars.
You buy a bond earning 5% in your 401(k). You pay tax on the full amount (principal and interest) when you withdraw money from your 401(k).

Scenario B:
You borrow money at 5% interest from your 401(k). You repay the loan with post-tax dollars.
You lend money at 5% interest from your 401(k). You pay tax on the full amount (principal and interest) when you withdraw the money from your 401(k).

There is no difference in the amount of tax you pay in either scenario! If scenario B is "double taxation," does that label apply to Scenario A as well?

While you pay the same amount of tax the difference is how the money is transferred and who has ownership.  In scenario B the interest money is after tax and then becomes pretax upon paying back the 401k loan.  The interest is still under your ownership so you are paying income tax on the same money twice. Scenario A the interest is going to a new owner (bank) while the interest on the bond comes from a previous owner (bond issuer)

Yep, the only difference between the scenarios is that in Scenario A you're borrowing money from a third party and your 401(k) is loaning money to a different third party, while in Scenario B your 401(k) is loaning money to you. In every other respect the transaction is identical. You get the same amount of liquid cash outside your 401(k), you pay the same interest rate on this cash, your 401(k) earns the same amount of interest, and you have the same tax-deferred balance at the end.

So by the same logic that your 401(k) loan interest is "double taxed" because you repaid the loan with post-tax dollars and you'll owe tax on the interest when it is eventually withdrawn, Scenario A is "double taxed" because you repaid the loan with post-tax dollars and the bank will owe tax on the interest. Heck, in Scenario A you also pay tax on the bond interest, and the bond issuer (if a for-profit entity) is repaying the bond with post-tax funds. Quadruple taxation?

They aren't identical though.  In scenario A the bond interest is generated from within your 401k and 100% of the taxes on that portion are deferred.   In scenario B you are taking your "post-tax" money (in an amount equal to the scenario A bond interest earned) and changing it into "pre-tax" money by repaying the interest portion of the loan, but without getting any tax deferment (like you do with normal 401k contributions). 

The rest of the details seem to make the example unnecessarily complicated and confusing.

I'm not trying to be confusing. The point is to show that the amount of tax you pay when you borrow from a third party outside of your 401(k) and lend to a third party from your 401(k) is exactly the same as when you borrow from your 401(k) directly. "You" and "your 401(k)" are treated as two different entities in this transaction. "You" pay the same tax whether you borrow from a bank or your 401(k), and "your 401(k)" pays the same tax whether it lends to "you" or someone else.

Why this is important is that if you need some cash and would otherwise consider borrowing from a bank, you should look to see how the interest rate from your 401(k) compares. It's quite possible that it would be a lower rate on the borrower side than taking a loan from a bank *and* a better return on your investment on the 401(k) side than if you went with a publicly available bond investment.

If this is the case, don't be dissuaded by the idea that you're somehow being taxed more if you did this than if you went down the alternative road of borrowing from a bank and keeping some fixed-income investments in your 401(k). It just isn't true.

The fact of the loan becoming due or taxable at the time you leave your job could be a very good reason not to take out the 401(k) loan. The "double taxation" simply isn't.

frugalnacho

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Re: 401K loans
« Reply #46 on: March 24, 2017, 07:49:43 PM »
You have to somehow earn that trillion dollars and pay taxes on it, before you can put it into your 401k, and you get no special tax treatment for putting that "interest" money into the account.  When you eventually withdraw that trillion dollars in the future you are also paying taxes on it.

EXACTLY.  I'll refer back to the article I linked to.  I think you're assuming that because you have to pay income tax on your wages to pay the interest on the loan, you're being taxed twice on the same money.  The fact that you had to pay income tax on the funds you earned to pay the interest on the loan is because the interest on that type of loan is not tax deductible.  It is unavoidable, and therefore irrelevant.  If you didn't take out a loan from your 401k and instead put your pay in your Scrooge McDuck pile, was it not all subject to taxation?  There was no way to pay zero tax on the income earned to pay the interest on the loan, so it shouldn't be viewed as subject to some sort of double-tax penalty.  You were always going to pay tax on that trillion dollars of income.  You were always going to pay tax on the 401k distribution.  Nothing changed just because you took the loan out from the 401k instead of a bank.

Just because I like to argue, what if you paid the interest back with a refundible tax credit like the EITC?  Then is the interest you paid double taxed?  Similarly, aren't YOUR tax deferred contributions to a 401k essentially double-taxed even if you never take a loan because the government had to have an offsetting income source to fund the tax deferrments in retirement plans?

I don't follow.

Scenario 1

1. I take out $100 loan from my 401k this year @ BIG^BIG %.
2. I earn $1.67T (I set aside $0.67T of that to pay my 40% income taxes), leaving me with $1T
3. I pay back $1T 401k loan.
4. I, rather stupidly, liquidate my 401k because I am of retirement age.  I get $1T, all of which is taxable income (I set aside 40% of this [$0.40T] for income taxes as well)
5. Now I claim my W2 income value of $1.67T plus the $1T 401k distribution for a total of $2.67T in taxable income.  (40% = $1.07T for taxes).

Cash = $0  + $100 from 401k, + $1.67T earned income, (-$1T back into your 401k, +$1T distributed out of your 401k), -$1.07T for taxes = $0.6T cash all said and done

Or

Scenario 2

1. Do not take out loan.
2. I earn $1.67T (I set aside $0.67T of that to pay my 40% income taxes), leaving me with $1T in my scrooge mcduck pile.

5. Now I claim my W2 income value of $1.67T in taxable income.  (40% = $0.67T for taxes).

Cash = $0, +$1.67T earned income, -$0.67T for taxes = $1T (in large pile I will swim in)


The difference between taking the 401k loan (scenario 1) and not taking it and just putting money into my scrooge mcduck pile (scenario 2) illustrates how you are double taxed on that.   There is a trillion dollars that is double counted as earned income on my W2 AND as income from a 401k distribution.  This is literally the exact same trillion dollars being counted twice on my tax forms.  If I wait to take a distribution from my 401k in a later year that tax is just delayed.  In reality you are dealing with much much larger loan amounts, and much much lower interest rates.  You can change the tax rate, and the loan terms, but the math is the same, the quantity of money double taxed will just be much smaller but still real.


Just because I like to argue, what if you paid the interest back with a refundible tax credit like the EITC?  Then is the interest you paid double taxed?  Similarly, aren't YOUR tax deferred contributions to a 401k essentially double-taxed even if you never take a loan because the government had to have an offsetting income source to fund the tax deferrments in retirement plans?

Because of the fungibility of money it’s irrelevant, but yes it is.  If you get the EITC, under normal circumstances the money doesn’t show up as income on your tax return, and can be considered “post-tax money”.  If you use it to pay back the interest portion of a 401k loan, then when you take a distribution that money will be counted as income and taxed. 

No my original contributions are not double-taxed.  Double taxed means some portion is literally counted twice on your personal tax return (not necessarily in the same year).

frugalnacho

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Re: 401K loans
« Reply #47 on: March 24, 2017, 08:33:03 PM »
Consider two scenarios:

Scenario A:
You borrow money at 5% interest from a bank. You repay the loan with post-tax dollars.
You buy a bond earning 5% in your 401(k). You pay tax on the full amount (principal and interest) when you withdraw money from your 401(k).

Scenario B:
You borrow money at 5% interest from your 401(k). You repay the loan with post-tax dollars.
You lend money at 5% interest from your 401(k). You pay tax on the full amount (principal and interest) when you withdraw the money from your 401(k).

There is no difference in the amount of tax you pay in either scenario! If scenario B is "double taxation," does that label apply to Scenario A as well?

While you pay the same amount of tax the difference is how the money is transferred and who has ownership.  In scenario B the interest money is after tax and then becomes pretax upon paying back the 401k loan.  The interest is still under your ownership so you are paying income tax on the same money twice. Scenario A the interest is going to a new owner (bank) while the interest on the bond comes from a previous owner (bond issuer)

Yep, the only difference between the scenarios is that in Scenario A you're borrowing money from a third party and your 401(k) is loaning money to a different third party, while in Scenario B your 401(k) is loaning money to you. In every other respect the transaction is identical. You get the same amount of liquid cash outside your 401(k), you pay the same interest rate on this cash, your 401(k) earns the same amount of interest, and you have the same tax-deferred balance at the end.

So by the same logic that your 401(k) loan interest is "double taxed" because you repaid the loan with post-tax dollars and you'll owe tax on the interest when it is eventually withdrawn, Scenario A is "double taxed" because you repaid the loan with post-tax dollars and the bank will owe tax on the interest. Heck, in Scenario A you also pay tax on the bond interest, and the bond issuer (if a for-profit entity) is repaying the bond with post-tax funds. Quadruple taxation?

They aren't identical though.  In scenario A the bond interest is generated from within your 401k and 100% of the taxes on that portion are deferred.   In scenario B you are taking your "post-tax" money (in an amount equal to the scenario A bond interest earned) and changing it into "pre-tax" money by repaying the interest portion of the loan, but without getting any tax deferment (like you do with normal 401k contributions). 

The rest of the details seem to make the example unnecessarily complicated and confusing.

I'm not trying to be confusing. The point is to show that the amount of tax you pay when you borrow from a third party outside of your 401(k) and lend to a third party from your 401(k) is exactly the same as when you borrow from your 401(k) directly. "You" and "your 401(k)" are treated as two different entities in this transaction. "You" pay the same tax whether you borrow from a bank or your 401(k), and "your 401(k)" pays the same tax whether it lends to "you" or someone else.

Why this is important is that if you need some cash and would otherwise consider borrowing from a bank, you should look to see how the interest rate from your 401(k) compares. It's quite possible that it would be a lower rate on the borrower side than taking a loan from a bank *and* a better return on your investment on the 401(k) side than if you went with a publicly available bond investment.

If this is the case, don't be dissuaded by the idea that you're somehow being taxed more if you did this than if you went down the alternative road of borrowing from a bank and keeping some fixed-income investments in your 401(k). It just isn't true.

The fact of the loan becoming due or taxable at the time you leave your job could be a very good reason not to take out the 401(k) loan. The "double taxation" simply isn't.

I'm not saying double taxation is a good reason to avoid a 401k, I'm just being pedantic.  The other factors like opportunity cost and interest rate should ultimately dominate the decision.  In fact the tax is being paid on money that wouldn't otherwise be yours anyway (if you take out a loan from a third party instead).

Going back to your examples, and simplifying them:


Scenario A:
You borrow money at 5% interest from a bank. You repay the loan with post-tax dollars.  The interest you pay is the cost of doing business and ends up as income for the bank.  It is lost to you forever, even though you've paid taxes on it and this is "post-tax" money.  Your tax forms are unchanged, as is your 401k and any eventual distributions
You buy a bond earning 5% in your 401(k). You pay tax on the full amount (principal and interest) when you withdraw money from your 401(k).

Scenario B:
You borrow money at 5% interest from a bank your 401(k). You repay the loan with post-tax dollars. The interest you pay is now inside your 401k (and is additional from the money that was already there plus the principal of the loan). Your tax forms are currently unchanged.
You lend money at 5% interest from your 401(k). You pay tax on the full amount (principal and interest) when you withdraw the money from your 401(k). The "full amount" you withdraw is the same quantity you had in your 401k in scenario A plus the "interest" you repaid with post-tax money

That "interest" portion is counted twice on your tax forms.  This is arguably better than losing that money forever by paying it to a bank instead of your own 401k, however other factors like opportunity cost, etc. are much bigger factors.

frugalnacho

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Re: 401K loans
« Reply #48 on: March 26, 2017, 02:55:22 PM »
I've been pondering this all weekend.   After an exchange with TFB he pointed out that the interest paid back to the 401k, and the interest you pay out are entirely separate and distinct items.  You are in no way "paying yourself interest" when you take a 401k loan.  You are paying interest on a loan, period.  Your 401k is gaining value by lending money at a certain percentage, period.  The fact that the money is going from you to your own 401k is irrelevant.  You might as well trade loans with seattlecyclone (ie your 401k lends to him, and his 401k lends to you - interest you pay with post-tax money is gone forever, and the increase in your 401k from his repayments will count as income when you withdraw it).

It's a bit of a mind fuck to me that the same physical bill of cash can show up on my W2 income twice (as in my thought experiment) but not be considered double taxed. 


seattlecyclone

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Re: 401K loans
« Reply #49 on: March 26, 2017, 05:48:17 PM »
Yes, this is something that makes my head hurt too. I'm glad you finally got there. Your 401(k) interest income is taxed the same whether the loan is paid by you or me.