Are 401k Plan Loans Double Taxed?

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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?

________________

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.

The 10 Biggest 401k Plan Misperceptions

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

Your 401k plan participants really believe some of the things outlined below!

Having worked as a 401k plan consultant for more than 30 years with some of the most prestigious companies in the world (e.g.; Apple, AT&T, IBM, John Deere, Northern Trust, Northwestern Mutual), I am always surprised by the simple but significant 401k misperceptions many plan participants have. Following are the most common and noteworthy 401k misperceptions:

401k Misperceptions

1. I only need to contribute up to the maximum company match

Many participants believe that their company is sending them a message on how much they should contribute. As a result, they will only contribute up to the maximum matched contribution percentage. In most plans that works out to be only 6% in employee contributions. Many studies have indicated that participants need to average at least 15% in contributions each year. To dispel the most common of all 401k misperceptions, and motivate participants to contribute something closer to what they should, plan sponsors should consider stretching their matching contribution.

2. It is OK to take a participant loan

I have had many participants tell me, “If this were a bad thing why would the company let me do it?” Account leakage via defaulted loans is one of the reasons why some participants never save enough for retirement. In addition, taking a participant loan is a horrible investment strategy. Plan participants should first explore taking a home equity loan, where the interest is tax deductible. Plan sponsors should consider curtailing or eliminating their loan provisions to eliminate one of the most misunderstood of all 401k misperceptions.

3. Rolling a 401k account into an IRA is a good idea

There are many investment advisors working hard to convince participants this is a good thing to do. However, higher fees, lack of free investment advice, use of higher cost investment options, lack of availability of stable value and guaranteed fund investment options and many other factors make this a bad idea for most participants.

4. My 401k account is a good way to save for college, a first home, etc.

When 401k plans were first rolled out to employees decades ago, human resources staff helped persuade skeptical employees to contribute by saying the plans could be used for saving for many different things. They shouldn’t be. It is a bad idea to use a 401k plan to save for an initial down payment on a home or to finance a home. Similarly, a 401k plan is not the best place to save for a child’s education — 529 plans work much better. Try to eliminate the language in your communication materials that promotes your 401k plan as a place to do anything other than save for retirement.

5. I should stop making 401k contributions when the stock market crashes

This is a more prevalent feeling among plan participants than you might think. I have had many participants say to me, “Bob, why should I invest my money in the stock market when it is going down. I’m just going to lose money!” These are the same individuals who will be rushing into the stock market at market tops. This logic is important to unravel with participants and an area that plan sponsors should emphasize in their employee education sessions.

6. Actively trading my 401k account will help me maximize my account balance

Trying to time the market, following newsletters or a trader’s advice, is rarely a winning strategy. Consistently adhering to an asset allocation strategy that is appropriate to a participant’s age and ability to bear risk is what plan sponsors should ensure is communicated through their employee education sessions.

7. Indexing is always superior to active management

Although index investing ensures a low-cost portfolio, it doesn’t guarantee superior performance or proper diversification. Access to commodity, real estate, multi-sector bond funds and many other diversifiers is sacrificed by many pure indexing strategies. A combination of active and passive investments often proves to be the best investment strategy for plan participants.

8. Target date funds are not good investments

Most experts who say that target date funds are not good investments are not comparing them to a participant’s allocations prior to investing in target date funds. Target date funds offer proper age-based diversification. Many participants, before investing in target date funds, may have invested in only one fund or a few funds that were inappropriate risk-wise for their age.

9. Money market funds are good investments

These funds have been guaranteed money losers for a number of years because they have not kept pace with inflation. Unless a participant is five years or less away from retirement or has difficulty taking on even a small amount of risk, these funds are below-average investments. As a result of the new money market fund rules, plan sponsors should offer guaranteed or stable value investment options instead.

10. I can contribute less because I will make my investments will work harder

Many participants have said to me, “Bob, I don’t have to contribute as much as others because I am going to make my investments do more of the work.” Most participants feel that the majority of their final account balance will come from the earnings in their 401k account. However, studies have shown that the major determinant of how much participants end up with at retirement is the amount of contributions they make, not the amount of earnings. This is another misperception that plan sponsors should work hard to unwind in their employee education sessions.

Make sure you address all of these 401k misperceptions in your next employee education sessions.

________________

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.

Should 401k Plans Offer Only Index Funds?

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

A number of retirement plan experts believe that 401k plan participants should only be allowed to invest in index funds. They say the additional cost that participants pay for actively managed mutual funds is not justified by better performance. Some 401k plan sponsors have agreed, offering only index funds in their fund lineups. Is that a good idea?

Arguments For Using Only Index Funds

[Read more…]

What Your 401k Investment Committee Should Discuss

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

If you are like most 401k plan sponsors, you worry about whether your 401k plan investment committee is focused on the right stuff. Is the investment committee using its time wisely talking about what is important? Or do you spend way too much time agonizing about investment performance? I believe that your 401k plan investment committee should focus on reviewing the following at their meetings: [Read more…]

Fiduciary Confusion: What’s A 401k Plan Sponsor To Do?

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

On February 3, President Trump signed a memorandum asking the Department of Labor to review the new fiduciary rules that apply to retirement accounts. The next week, on February 9, the Department of Labor (DoL) filed documents that will likely result in a six-month delay of the scheduled April implementation of the rules. There have been a lot of comments circulated on the impact of a delay or any changes. And of course, debate has once again been revived on the value of these new rules. Most important, though, is what this means for your 401k plan and participants and what your 401k fiduciary responsibility is. [Read more…]

How To Avoid A DoL 401k Audit

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

There are many reasons for plan sponsors to do everything possible to avoid a Department of Labor (DoL) 401k audit. They can be costly, time-consuming and generally unpleasant.

The DoL in its Fact Sheet for fiscal year 2016 indicates that the Employee Benefits Security Administration (EBSA) closed 2,002 civil investigations with 1,356 of those cases (67.7%) resulting in monetary penalties/additional contributions. The total amount EBSA recovered for Employee Retirement Income Security Act (ERISA) plan participants last year was $777.5 million.

In my experience, if you receive notification from the DoL that it has an interest in looking over your 401k plan, you need to be concerned. Not only do the statistics above support the fact that DoL auditors do a good job of uncovering problems but in my opinion, they are not an easy group to negotiate with to fix deficiencies.

As a result, I believe the best policy to follow to ensure you don’t receive a visit from a DoL representative is to do everything possible to avoid encouraging such a visit. Here are some suggestions that may help you avoid a DoL 401k audit: [Read more…]

What’s The Right 401k Contribution Rate?

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

The most frequent question I receive from 401k participants is, “How much should I contribute?” My answer is always the same, “As much as you possibly can.” That never seems to satisfy anyone, so I typically go on to explain the following.

The correct 401k contribution rate

[Read more…]

Six New Year’s Resolutions 401k Plan Sponsors Should Make

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

I hope that 2016 was a great year for you and that 2017 will be even better!

A few changes can make your good 401k plan into a great one. To help your 401k plan achieve greatness, consider making the following 401k plan improvements by year-end: [Read more…]

401k Plan/Financial Wellness Education Best Practices

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

Have you started planning your 2017 401k employee education sessions? Generally, most plan sponsors conduct employee education sessions during the early part of the new year to explain changes that went into effect on January 1. As you think about your 2017 education sessions, keep the following 401k education best practices in mind: [Read more…]

Top 10 401k Trends For 2017

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

Competition for qualified employees is becoming intense. As a result, firms that you compete with for talent will be buffing up their benefits packages in 2017. Listed below are the changes that leading-edge employers will make to their 401k plans as a result of the most important 2017 401k trends. Although these 2017 401k trends are numbered, they are not shown in order of importance – all of these items are equally important. [Read more…]