Not advising everyone go out and take a 401k loan, but the 401k loan "double taxation" is a myth. Probably the easiest way to explain it is this way: You take out a $10,000 401k loan, you put that money in your pocket, two months later you pay the loan back with that exact same $10,000 you've had in your pocket the whole time.....your taxes are not affected one bit, obviously. http://www.federalreserve.gov/pubs/feds/2008/200842/200842pap.pdf LINK LINK LINK LINK
3.2 Tax Considerations
401(k) loans are sometimes described as facing double taxation, because (unlike regular
contributions) loan payments are made with after-tax dollars, and then account assets
are taxed again upon withdrawal in retirement.11 This argument turns out to be wrong,
because in practice, the tax treatment of 401(k) loans does little to alter the tax-preferred,
“consumption-tax” treatment of retirement accounts. To see why, consider the following
illustration of the consequences of taking a 401(k) loan, from a consumption-tax perspective.
Traditional retirement accounts implement consumption-tax principles (i.e., that wages
should be taxed when they are consumed rather than when they are earned) by offering
a tax deduction for wages contributed to the account, and then taxing withdrawals of
contributions and their earnings as ordinary income. Since the idea of a consumption tax
is to tax consumption rather than saving, “traditional” consumption tax treatment of a
401(k) loan would be to tax the loan when it’s taken, but not the repayments. In the real
world, the situation is reversed: loan proceeds are not taxed, but no deduction is offered
for repayments. Thus the timing of tax deductions and payments for an account with
a loan is exactly the same as one without a loan—a deduction is offered for the initial
contribution, withdrawals in retirement are fully taxed, and no other deductions are offered
in the interim.12
What about the charge that loan payments are “double-taxed”, once upon repayment
and again upon withdrawal in retirement? This turns out to be a mirage: the loan principal
is clearly taxed only once—when it is repaid with after-tax dollars. Since loan proceeds
are not taxed when distributed, the tax on repayment is really just a delayed tax on the
consumption of the loan proceeds. The “second” tax, upon withdrawal in retirement, is tax
on the consumption of the repayments in retirement. Thus each dollar of consumption is
taxed just once.
It's complex to think about in your head, so I understand why some people think double taxation, but here is an example that I find easier to understand:
Suze insists that taking a 401k loan results in double-taxation of the principal, as one repays tax-exempt money with after-tax money.
But she is using flawed reasoning, and here is why: MONEY is FUNGIBLE.
Do the following thought experiment:
You take out $20k from your savings account (after-tax $$) to buy a car and place it in an envelope.
Then you take out a $20k loan from your 401k, and put that into an identical envelope.
You go buy the car and pay for it with the cash from one of the envelopes, having forgotten which was which.
You then repay the loan with the contents of the OTHER envelope.
NOW, did you repay the loan with pre-tax or post-tax money?
You would never know as there is NO DIFFERENCE.
This post was edited on 7/10 at 4:13 pm