Are 401 (k) loan repayments double taxed?

Question

My wife and I took out a 401 (k) loan to help cover the costs of renovating our newly acquired home.

We paid off the loan at 401 (k), but we still have a way to go. As you know, the loan repayments themselves are taxed and any withdrawals are taxed as well, creating adverse double taxation.

Since we are already paying taxes on the loan repayment, can we repay the loan to a Roth IRA? This would allow us to avoid the withdrawal tax and the possibility of growing our investments tax-free! We searched online but found no information. Please help yourself!

Reply

It is a subject that is often misunderstood and can easily give rise to misinterpretations, says Dennis LaVoy, a Certified Financial Planner with Telos Financial.

The short answer to your question is no, you can’t borrow from a traditional 401 (k) and pay off a Roth 401 (k), LaVoy says. “It would be pretty cool if you could, but it’s just not allowed. Loan repayments go back to where they came from the way they went.

Also, when you borrow from a 401 (k), most plans dictate how those funds are to be withdrawn. “For example, let’s say you have a 401 (k) worth $ 100,000 and $ 50,000 of that amount is traditional or pre-tax and $ 50,000 from Roth,” says LaVoy. “Suppose you decide to take out a loan from your 401 (k) for $ 50,000. Your 401 (k) plan document should provide some guidance on how your withdrawal will play out. “

It may indicate, for example, that the loans originate first before tax or in proportion to each area of ​​tax status, as a few examples. “Normally you can’t make that choice,” LaVoy says.

Next, let’s clear up a misstatement you made and have a bit of a chat.

There is no real double taxation on the repayment of the loan. It’s easy to see how you come to this conclusion, but it’s just plain wrong.

According to LaVoy, the money comes in after tax and you have to pay taxes again when you take it out.

“When you repay that it’s after tax and when you withdraw in the future you have to pay tax again; but remember that the money you pay back, you’ve already received tax-free deposits and growth that were all tax-free, ”says LaVoy. “That withdrawal that you spent is really the money that you pay taxes on through your refund. It is a lump sum that you get tax free. The 401 (k) loan simply gives you the option to defer the tax bill to align it with your repayment schedule over a number of years, making it a more beneficial strategy from a pure tax perspective.

How about an illustration to help clarify.

Let’s say you borrow $ 50,000 from your traditional 401 (k). The money comes in tax free and comes out tax free. Now let’s say you bury that money in a coffee can in your backyard. You still saved money without paying taxes on it and received the loan proceeds without paying taxes on it. Now, after a certain period, a month, a year, a week, whatever, you dig the box, still with $ 50,000, and you pay off the loan. The money comes in, the money goes out, the money comes in, never taxed. It would later be taxed on retirement when you make a withdrawal. So no duplicate taxes here, right? You took the money tax-free and paid it back tax-free.

“To think that this is double taxation is to forget that you received a distribution in the form of a loan that was never taxed,” says LaVoy. “If you look at it on a consumption basis, that is, funds are taxed when they are spent, you pay tax on it as you earn it over the next few years.” years, again delaying tax liability. If you didn’t have to pay off a 401 (k) loan with after-tax dollars, you would avoid tax on that loan altogether and it would be a major loophole to get 401 (k) s tax-free distributions.

There’s a case to be made that the interest you pay back is double taxed, says LaVoy. “But you can also say that you get a discount and have the ability to add more to your 401 (k) than the limits allow. It depends on the yield and tax assumptions on which side you you stand, ”he said.

This is where there is an argument to be made, says Lavoy. “The money you pay back in interest could probably be double taxed,” he says.

Let’s say you took out a loan for $ 100 and paid it off over several years, so the total you paid back was $ 110. That $ 100 was money you spent (presumably when you took out the loan) and paid distribution taxes since they weren’t taxed before (via repayment to the account).

The $ 10 you paid in interest could be considered double taxed. As it is after-tax money that is put into the account which will be taxed again upon withdrawal. It is not a replacement for a cast or a new dollar that you have consumed.

Whether it’s double taxation or not is really an academic argument, says LaVoy. “It’s basically about debating what’s more important, the pre-tax rate of return used in the time value of money or the interest rate paid on the loan,” he says. “It can get complicated quickly, but basically is the interest paid more than the value of the time you borrowed the funds.”

About Arla Lacy

Check Also

Henderson wants to be No.1 Man United, and despite a quiet night against West Ham, he pleads to oust De Gea

February 9, 2021 Rob dawsonCorresponding MANCHESTER, England – For 120 minutes at Old Trafford on …