By Robert C. Lawton, AIF, CRPS, President, Lawton Retirement Plan Consultants, LLC

Are 401k plan loans double taxed? As outlined in the example below, it appears that the principal amounts of 401k loans that are distributed at retirement are taxed at a rate that is more than double that of a participant’s incremental tax rate.

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% federal tax bracket while working and when retired.
  • No state taxes.
  • To eliminate the impact of interest, assume the interest rate on this 401k plan loan is 0%.
  • 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% 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%), more than double the amount of $2,500 (25%) 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 401k 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?

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About the Author

Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC. Mr. Lawton is an award-winning 401(k) investment adviser with over 30 years of experience. He has consulted with many Fortune 500 companies, including: Aon Hewitt, Apple, AT&T, First Interstate Bank, Florida Power & Light, General Dynamics, Houghton Mifflin Harcourt, IBM, John Deere, Mazda Motor Corporation, Northwestern Mutual, Northern Trust Company, Trek Bikes, Tribune Company, Underwriters Labs and many others. Mr. Lawton may be contacted at (414) 828-4015 or bob@lawtonrpc.com.

About Lawton Retirement Plan Consultants, LLC

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 401(k) plan sponsors. The firm currently has contracts in place to provide consulting services on more than $400 million in plan assets. 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. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser.

Important Disclosures

This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance, tax, legal or investment advice. Each plan has unique requirements and you should consult your attorney or tax adviser for guidance on your specific situation. In no way does Lawton Retirement Plan Consultants, LLC assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations. Investors should carefully consider investment objectives, risks, charges and expenses. The statements in this publication are the opinions and beliefs of the commentator expressed when the commentary was made and are not intended to represent that person’s opinions and beliefs at any other time. The commentary does not necessarily reflect the opinion of Lawton Retirement Plan Consultants, LLC and should not be construed as recommendations or investment advice. Lawton Retirement Plan Consultants, LLC offers no tax, legal or accounting advice, and any advice contained herein is not specific to any individual, entity or retirement plan, but rather general in nature and, therefore, should not be relied upon for specific investment situations. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser and accepts clients outside of Wisconsin based upon applicable state registration regulations and the “de minimus” exception.