By Barry C. Picker, CPA/PFS, CFP
Question: I hear from some people that I should never borrow money from my 401(k) plan, because the money in the plan ends up being double taxed. Is this accurate?
Answer: In a word, no. But before I explain why, let me first emphasize that 401(k) loans are not ideal, particularly if one should default on the loan. A default results in immediate taxation of the outstanding loan amount, and if the defaulter is under the age of 59½, the 10% early withdrawal penalty is added on. All of this on phantom income. This is the worst case scenario.
Back to the question. The answer can best be illustrated by way of example.
Let’s assume I have $100K in a 401(k), and zero cash. I have $10K of income that is coming to me from work, and I’m in the 40% tax bracket. I want to buy a big HDTV for $6K. I have 4 ways to handling this.
Possibility #1: I wait until I get the $10K income, pay $4K in tax, buy the TV. Result: I have a TV, zero cash, and $100K in the 401(k). If I pull out the $100K from the 401(k), I’ll pay $40K tax and have $60K cash. Bottom line, I’ve paid $44K in tax and I have a TV and $60K cash.
Possibility #2: I don’t wait and I take $10K from the 401(k), pay $4K tax and pay $6K for the TV. (This ignores the 10% early withdrawal tax for someone under the age of 59½). I now receive the $10K of income, pay $4K of tax on that income and have $6K of cash and $90K in the 401(k). If I pull out the $90K from the 401(k), I’ll pay $36K in tax and net $54K. Bottom line, I’ve paid $44K in tax and I have a TV and $60K cash.
Possibility #3: I borrow $6K from a friend, and when I get the $10K of income and pay the $4K in tax, I pay the net $6K back to my friend. Result: I have a TV, zero cash, and $100K in the 401(k). If I pull out the $100K from the 401(k), I’ll pay $40K tax and have $60K cash. Bottom line, I’ve paid $44K in tax and I have a TV and $60K cash.
Possibility #4: I borrow the $6K from my 401(k) and buy the TV. When the $10K income comes in, I pay the $4K in tax and pay back the $6K 401(k) loan. At this point, I have the TV, zero cash and $100K in the 401(k). If I pull out the 401(k), I’ll pay $40K tax and have $60K cash. Bottom line, I’ve paid $44K in tax and I have a TV and $60K cash.
So any way you decide to work the deal, there is one tax on the $10K of income, and one tax on the $100K 401(k).
Then why does it appear that there’s double taxation? Look at Possibility #4. The $6K that I used to pay back the 401(k) loan has already been taxed. Now when I pull out that $6K as part of the $100K withdrawal, it’s taxed again. Isn’t that $6K double taxed?
If you think of that specific $6K as dollar bills as it moves through my finances, it sure does appear that way. But dollars are fungible; one bill is the same as another.
So looking solely at the $6K creates this ‘optical illusion’ of double taxation. It takes your ‘vision’ away from the fact that the $6K had come out of the 401(k) in the form of a loan, and that $6K was able to go into my pocket without being taxed.
Bottom line is that you can’t look at only a small segment of the financial transaction (the payback of the loan). You have to look at the entire picture (the borrowing as well as the payback, the use of the funds, etc.) and you’ll see that from a strict financial flow of money, as explained in the 4 Possibility examples above, the 401(k) loan does not cause an increase in taxes (all other things being equal), which is what double taxation implies.
