Time to Rebut a Misconception: The Hypotheses - Retirement Plan Loans are Double Taxed is an informative article in the Spring 2008 edition of the ASPPA Journal (page 36) that ranks the order of priority for personal loan resources:
- Home Equity Loan
The article also asserts that the theory that borrowed money is double taxed because the loan is paid back with after-tax dollars is inaccurate:
While it may be true that the interest paid by the borrower is double taxed, that simply reduces the net return paid by the participant for the loan, and that rate may be better than he or she is earning in the account had the loan not been taken.
It provides an oversimplified example, a typical example, and a pure theory example.
Should I Borrow From My 401(k)?
Should I Borrow From My 401(k) Plan? discusses reasons to take out or avoid taking out a 401(k) loan. It is important to understand the pros and cons of 401(k) participant loans and the facts and circumstances of the individual:
A good reason to take out a 401(k) loan is because:
- There is no credit check.
- It is convenient. For many plans you can apply online or with a telephone system in a matter of minutes.
- The interest you are paying is reasonable. The rate is set by the plan and is usually one or two points above the prime rate.
- There are no restrictions. You can borrow at any time for any reason.
- You are paying interest to yourself.
- The interest you are paying yourself is providing you with a reasonable rate of return.
- You do not have to pay taxes on the interest you are earning until retirement (or when you take a taxable distribution).
- You select which investments will be sold to fund the loan.
A good reason to avoid taking out a 401(k) loan is because:
- If you leave the company for any reason, you will most likely have to pay the loan in full right away. If you cannot pay the loan right away (usually within 60 days), you will be in default, taxed on the full balance, and may need to pay a 10% penalty.
- You may need to reduce the contributions you are making to your 401(k) plan to make the loan payments. This will ultimately reduce the amount available to you at retirement.
- The interest you are paying yourself could provide a smaller rate of return than the investments that the money would have otherwise been invested in. This "opportunity cost" will be compounded over time and ultimately reduce the amount available to you at retirement.
- The interest you are paying yourself will be taxed twice, once when you originally earned the money (e.g. from your paycheck) and again when it is withdrawn from the plan. (See above discussion)
- You have very limited flexibility with setting up or changing the payment terms of the loan.
- You are spending money that you have already saved.
- You may change your retirement savings mindset. The money you are saving is for your retirement.
- You may be charged loan fees.
Updates/Related Blog Posts:
- 401(k) Debit Cards How Do They Work and Are They a Good Idea (1/19/08)
- 401(k) Debit Card/Line of Credit (8/16/07)
- Should I Borrow From My 401(k) Plan? (1/8/07)