Are 401 (k) Plan Loans Double Taxed?
Are 401 (k) Plan Loans Double Taxed? As shown in the example below, it appears that the principal amounts of 401 (k) loans that are distributed at retirement are taxed at a rate that is more than double a participant’s differential tax rate.
Here are the assumptions:
· 401 (k) plan loan amount of $ 10,000.
· Payroll deduction is the only way to repay this loan.
· The member is in the 25% federal tax bracket while working and retired.
· No state taxes.
· To eliminate the impact of interest, assume the interest rate on this 401 (k) plan loan is 0%.
· To simplify the example, suppose there is only one payroll deduction payment of $ 10,000 to repay the loan.
Origin of the loan: $ 10,000, no tax impact
Loan repayment: An after-tax payment of $ 10,000 deducted from payroll. $ 13,333 in gross earnings required to make the after-tax payment of $ 10,000, resulting in $ 3,333 in taxes attributable to the payment.
Distribution of this $ 10,000 at retirement: $ 10,000 taxed at 25% resulting in $ 2,500 in taxes.
The total taxes paid on the $ 10,000 used for the 401 (k) plan loan and then distributed at retirement are $ 5,833 (58%), more than double the amount of $ 2,500 (25%) that would be paid out of a distribution of $ 10,000 at retirement.
Same as any other loan?
Many financial experts believe that 401 (k) loans are not double taxed. They say the overall tax treatment of the individual is the same whether they take out a 401 (k) loan or a loan for that matter. An equivalent amount of taxes would be required to repay a loan from any other lender. I am okay. However, this does not change the fact that a participant appears to incur a tax on the principal portion of 401 (k) loans which is more than double their differential tax rate.
401 (k) loans are bad
I believe that take 401 (k) loans is a bad financial decision because many reasons. One reason is that the interest on the loan is not tax deductible (like a home equity loan). In addition, the lender (the plan) is obligated to lend to a borrower (the participant), whether or not the participant is creditworthy. Thus, 401 (k) plans often become the lender of last resort for many participants who do not have to take on more debt. Many of these participants end up failing on their loans if they lose their job or leave for a new job, as member loans become due immediately in most plans when a member leaves service.
Additionally, most participants who take 401 (k) loans end up reducing or stopping their contributions while making their repayments. As a result, they often lose the company’s matching contributions since they no longer contribute up to the maximum matching percentage.
What do you think: are 401 (k) loans double taxed? Is taking a 401 (k) loan a bad financial decision?
Robert C. Lawton, AIF, CRPS is President of Lawton Retirement Plan Consultants, LLC, an RIA company helping 401 (k) plan sponsors with their investment, fiduciary, employee training and compliance responsibilities.