Are 401k Loans Double-Taxed?

Let’s take a look

401k loans, retirement, taxesAnother possible reason to discourage leakage.

Interesting question. It appears that the principal amount of 401k loans distributed at retirement are taxed at a rate that is more than double that of a participant’s incremental rate. Does it mean they’re double-taxed? Consider the following:

Assumptions

  • 401k plan loan amount of $10,000
  • Payroll deduction is the only way to pay back this loan
  • The participant is in the 25 percent federal tax bracket while working and when retired
  • No state taxes
  • To eliminate the impact of interest, assume the interest rate on this plan loan is 0 percent
  • To simplify the example, assume only one payroll deduction payment for $10,000 to pay back the loan

Example

Loan origination: $10,000, no tax impact

Loan payback: One $10,000 payroll-deducted after-tax payment. $13,333 in gross earnings needed to realize the $10,000 after-tax payment resulting in $3,333 in taxes attributable to the payment.

Distribution of this $10,000 at retirement: $10,000 taxed at 25 percent resulting in $2,500 in taxes.

The total taxes paid on the $10,000 used for the 401k plan loan and then distributed at retirement are $5,833 (58 percent), more than double the amount of $2,500 (25 percent) that would be paid on a $10,000 distribution at retirement.

Same as Any Other Loan?

Many financial experts believe that 401k loans are not double taxed. They say that the overall tax treatment of the individual is the same whether he/she takes a 401k plan loan or a loan from somewhere else.

An equivalent amount of taxes would be required to pay back a loan from any other lender. I agree. However, that does not change the fact that a participant appears to experience a tax on the principal portion of loans that is more than double his/her incremental tax rate.

401k Loans Are Bad

I believe that taking 401k loans is a bad financial decision for many reasons. One reason is that the loan interest is not tax deductible (like a home equity loan). Also, the lender (the plan) is required to lend to a borrower (the participant) regardless of whether the participant is creditworthy.

So 401k plans often become the lender of last resort for many participants who have no business taking on additional debt. Many of these participants end up defaulting on their loans if they lose their jobs or leave for new jobs, because participant loans become immediately due in most plans when a participant separates from service.

In addition, most participants who take 401k loans end up reducing or stopping their contributions while making loan payments. As a result, they often lose company matching contributions since they no longer contribute up to the maximum matched percentage.

What do you think, are 401k loans double taxed? Is taking a 401k plan loan a bad financial decision?

Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC. Lawton is an award-winning 401k investment adviser with over 30 years of experience. Lawton Retirement Plan Consultants, LLC is a Milwaukee, Wisconsin-based independent, objective Registered Investment Adviser (RIA) providing investment advisory, fiduciary compliance, employee education, provider management and plan design services to 401k plan sponsors. For more information, please contact Robert C. Lawton at (414) 828-4015 or bob@lawtonrpc.com or visit the firm’s website at: http://www.lawtonrpc.com.

6 Comments on "Are 401k Loans Double-Taxed?"

  1. 401k loans are not doubled taxed, it’s the interest on those loans that are double taxed. Interest is required by the IRS on a 401(k) loan and it’s re-paid with after tax dollars that are then taxed again when taken out in retirement. You can’t make the assumption that the interest rate on a plan loan is zero.

    • Ed McNicholas | April 21, 2017 at 6:53 am | Reply

      Agreed, just the interest paid on the loan is double-taxed when borrowing from pre-tax sources. However, for plan loan taken from Roth source money there is no double-tax.

  2. David Richards | April 21, 2017 at 12:50 pm | Reply

    To the two posters whom stated that loans are not double-taxed, please explain the $3,333 cost to pay back the pre-tax loan amount. If the employee had never taken that loan, at retirement when he takes that $10,000 distribution, he would only pay $2,500 in taxes. However, due to the repayment of the loan with after-tax dollars, the employee is incurring an additional $3,333 ON TOP OF the $2,500. If that’s not double taxation, I don’t know what is!

    Put another way, it required the employee to earn $13,333 to receive $7,500 at retirement WITH the loan; whereas it only required the employee to earn $10,000 to receive $7,500 at retirement WITHOUT the loan.

    • Raymond Suelzer | August 16, 2017 at 6:46 pm | Reply

      If you take out a $10,000 loan from a bank you still have to pay it with after-tax dollars. You never paid taxes on the $10,000 going in and you don’t pay any taxes taking it out. There is no double taxation on the principal of the loan. The interest you pay is theoretically taxed twice because it is not subject to ROTH status even though it is an after-tax contribution. But for the vast majority of loans you are looking at maybe $100-$200 in additional taxes, which is lower than many fees banks charge for personal loans.

      The only scenario where loaning yourself money from your 401k is bad would be:
      1) You do not repay your loan on time
      2) You lower your contributions to pay off the loan, although this might happen if you have a loan from a bank.

      Finally, the third scenario is the only one in which you could really lose out, but it is also impossible to predict.
      3) Your investments would have made more money than the interest you are paying on them. Although if your investments end up losing money, then you come out ahead.

  3. David. Look at the income streams not the 401k.
    Start
    401k Balance = 0
    Earn $10k deposit into 401k – Taxes paid = $0 – 401k Balance = $10k
    Take $10k Loan – Taxes paid = $0 – 401k Balance = $0
    Earn $13k Taxes paid $3k – Repay Loan $10k – 401k balance = $401k

    At this point you have earned $23k but only paid taxes on $13k

    Retire and take out $10k – Taxes $2.5k.
    Total Earnings $23k Taxes paid $3.5k

    You paid never were taxed on the same income twice.

    The original $10k balance did not just magically appear it was earned but no taxes were paid.

  4. Sorry typo on the total tax fixed below
    David. Look at the income streams not the 401k.
    Start
    401k Balance = 0
    Earn $10k deposit into 401k – Taxes paid = $0 – 401k Balance = $10k
    Take $10k Loan – Taxes paid = $0 – 401k Balance = $0
    Earn $13k Taxes paid $3k – Repay Loan $10k – 401k balance = $401k

    At this point you have earned $23k but only paid taxes on $13k

    Retire and take out $10k – Taxes $2.5k.
    Total Earnings $23k Taxes paid $5.5k

    Yo never were taxed on the same income twice.

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