401(k) loans: Are you really taxed twice?

Posted by on July 24, 2009 @ 9:23 am in Investing

Following my recent post on 401(k) loans, a number of you asked for more detail on the rules around taxes on plan loans and repayments. So I thought I’d delve deeper into the topic of being (or not being) taxed twice.

Two things are important. First, it’s easy to see you aren’t “taxed twice” on the principal balance of a “k” loan. If you borrow $10,000 from your retirement plan, you receive $10,000 to use as you want—you don’t have to pay taxes on it. Putting that money back into your plan account doesn’t involve paying additional taxes. You’re just repaying money you borrowed. Yes, you’re using after-tax money to replace your pre-tax money. But you also used pre-tax money to, for example, buy a car, or pay off credit cards, so it all evens out. (Looking at it another way—if you want to think of the $10,000 you’re using to repay your loan as a discrete sum of money, you may argue that it gets taxed when you first receive it as income and again when you withdraw it in retirement. But the “other” $10,000—the money you withdraw as a loan—never gets taxed. Not when you first stick it in the 401(k), and not when you take it out and use it.)

Second, on the interest component, it’s more complicated. Here, the “interest” you’re paying on a retirement plan loan is new money you are putting into your account. You’re using after-tax dollars to make these interest payments/contributions, as opposed to the pre-tax dollars that you might normally put into the plan. When the money comes out in retirement, however, you owe income tax on this “interest” at the same rate as the other pre-tax amounts in the plan. So, in this sense, you “pay tax twice” on the interest.

While this seems to make intuitive sense—and might seem to represent an important cost of a 401(k) loan—there is a subtle issue here.

Suppose, just for a minute, that your entire 401(k) were entirely invested in bonds offered by your local bank (which is silly, and not a recommendation of any kind, but will help me make this point). If you had borrowed $10,000 from that bank instead of your retirement plan, you would pay the interest you owe on the loan out of your after-tax income. But the bank would turn around and take your interest (and that of its other creditors) and use it to pay interest it owes on its bonds—among other things—which you hold in your 401(k). That interest is what accrues in your account, and you will pay income taxes on it (again) when you draw it out in retirement.

This example highlights the fact that all interest you receive is, in this sense, “taxed twice.” Of course, the big difference is that in a 401(k)-style plan the “interest” is entirely your own money—not that of the bank’s creditors. So, while the “taxed twice” thing is absolutely true with respect to the interest, it’s not clear that it’s relevant at all to the loan decision. The other factors I mentioned in my previous post are what you should really focus on.

This example highlights the fact that all interest you receive originates from someone else’s after-tax income, and is in this sense ultimately “taxed twice.” Of course, the big difference is just that with a k-plan loan, the “interest” is entirely your own money, not that of the bank’s creditors. So while the “taxed-twice” thing is absolutely true with respect to the interest, it’s not clear that it’s relevant at all to the loan decision. (Though the very technically inclined might want to look at this paper from the Federal Reserve, which suggests that a cost could creep in, given particular differences in rates of return.)

The bottom line: In general, the other factors I mentioned in the original post are what you should really focus on.

Notes:

• Consider consulting a tax or financial advisor about your individual situation.

• The link to FederalReserve.gov will open a new browser window. Vanguard accepts no responsibility for content on third-party sites.

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