Author Topic: 401K loans  (Read 6815 times)

frugalnacho

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Re: 401K loans
« Reply #50 on: March 26, 2017, 08:40:29 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.

It certainly doesn't help that financial advisers, bloggers, and even the federal reserve conflate the ideas rather than stating that important distinction (that it's irrelevant where the interest payments come from). 

https://www.federalreserve.gov/pubs/feds/2008/200842/200842pap.pdf

Quote
Loan interest payments, on the other hand, can indeed be considered double-taxed under traditional consumption tax principles—since interest payments are like new contributions, they should be made with pre-tax dollars and then taxed upon withdrawal. In practice, however, the double-taxation of loan interest relative to a consumption tax is offset by the break borrowers get on the timing of their tax payments: recall that rather than paying taxes on loan proceeds when they are distributed (i.e., consumed), borrowers pay the taxes gradually over the following five years as they repay the loan with after-tax dollars. The time value of these delayed tax payments offsets the double taxation of interest—perfectly so, if the discount rate is the pre-tax rate of return; only partially if the discount rate is lower.

I've not even been considering the scenario of 401k loan vs commercial loan.  My though experiments only considered 401k loan vs no loan, which I thought was a reasonable comparison for some people (like someone with terrible credit, or someone who filed bankruptcy yet has a 401k balance they could borrow against.  Their options are 401k loan or nothing.  Plus it seemed conceptually easier to understand without lumping in additional loans).  I understand how you can consider that you are not getting double taxed (as explained in this thread), yet it certainly does seem like you are getting double taxed when you are the borrower and the lender.  Even in this thread it's been mentioned that you are "paying interest to yourself", which is just wrong.