401(k) Loans: Savvy Financial Tool or Tax Trap?

May 4, 2021

Planning & Saving

Avi Ostman needed cash to pay for an upcoming bar mitzvah. The plan was to borrow $10,000 from his workplace 401(k) account. He had about $50,000 sitting there after years of withholding a bit of his paycheck and collecting a company match. Why not tap into that pot now, he figured, instead of running around to borrow from gemachs or friends? But then he heard a financial podcast mention what a terrible idea 401(k) loans are. The fellow claimed with these unusual transactions the IRS taxes you twice on the same money!

Avi was now completely confused—are 401(k) loans savvy or silly?

Diners and Disappearing Dollars

Before we delve into this baffling topic, consider this old brain teaser. A group of three bought sandwiches at a diner. The cashier charged them $30, so each man paid $10 and they sat down to eat. A while later, the cashier realized the bill was really only $25, so he sent a waiter to refund the $5. But the waiter only gave each man $1 back and kept the other $2 for himself. Now the three fellows paid $9 each for lunch, which is $27. Add the $2 that the waiter kept, and that’s $29. But the three men paid $30 originally. Where is the other dollar?”

Mental Math Errors

I start with this introduction to highlight that as with optical illusions, our intuitive brains don’t always follow mathematical reality. Obviously, a dollar didn’t just disappear—there’s a mental catch hidden in that diner example (explained at the end if you didn’t catch it). So too, even some famous financial personalities have come to the intuitive but erroneous conclusion that 401(k) loans lead to double taxation. Suze Orman, for example, the author of multiple best-selling personal finance books, is one of the primary spreaders of this faulty information over the years.

Double Tax?

Here’s how the tax argument against 401(k) loans goes. After borrowing pre-tax money from a 401(k) account, the loan is typically repaid over a number of years out of the employee’s paycheck—with income tax withheld—that’s tax number one. When these funds are then withdrawn in retirement, they are again taxed, #2. This seems straightforward and obvious, as in 1+1=2. But like the disappearing dollar example, the supposed double taxation of 401(k) loans is a mental illusion, caused by confusing the numbers flow. There are really two sets of earning and spending going on with 401(k) loans—and each is taxed separately.

Gift Proof

One hint that 401(k) loans aren’t double-taxed is a case where the borrower doesn’t pay back the funds using their paycheck. Say Avi removes the $10,000 from his 401(k) account and then suddenly gets a gift of the same amount. By sending those funds back to the 401(k) account, the loan is deemed repaid in full without any taxation. Only decades later, upon a permanent withdrawal, is the $10,000 going to be taxed. Once. Clearly, it’s not the loan that triggers a tax liability.

Same as Any Loan

To illustrate further, say Avi, scared off by the naysayers, leaves the 401(k) account alone and doesn’t get any lucky gifts either. Instead, he makes his bar mitzvah by borrowing $10,000 from a friend. Repaying that loan principal will actually require him to earn him $12,500 (assuming 20% tax- that’s tax #1). And then the untouched $10,000 still sitting in his 401(k) will be taxed upon withdrawal, tax #2. There are two taxes here on two different sets of earnings/spending. One pays for the bar mitzvah. The other for a retirement party, perhaps. The need to pay tax on the bar mitzvah earning/spending has nothing to do with where that $10,000 comes from.

From Post-tax to Post-tax

The same cash flows—borrow, spend, earn, pay tax, repay loan—occur whether the $10,000 is borrowed from a bank or from the 401(k) account. Except that borrowing from one’s own account means there’s no begging a bank for approval, and interest is paid to oneself (i.e., deposited into the 401(k) account). Since a loan is provided on a post-tax basis, it needs to be repaid with post-tax dollars. In fact, to expect otherwise would be to expect a tax deduction on the loan! And no loan offers that (only mortgage interest is deductible).

The Added Cost of Tax

As a related aside, most don’t think of it this way but virtually all of our spending is post-tax. A $10,000 bar mitzvah really costs you $12,5000 in that you have to earn that much to have $10,000 left after taxes. The same for the car lease, jewelry, food, clothing, and everything else that doesn’t enjoy a tax deduction. This perspective is another way of highlighting the value of maximizing tax efficiency. (I had a dream during the Trump administration that he’d have gotten yeshivah tuition to be tax deductible. That would be equivalent to a 20–40 percent tuition discount for all!)

Borrow if You Must

Getting back to the bottom line though, 401(k) loans don’t raise any tax issues. There are other reasons not to treat your 401(k) as a piggy bank—mainly in that the money won’t be invested in the interim. But a 401(k) loan can definitely stack up well when compared to other options such as credit cards. Another bottom-line lesson is—don’t believe everything you hear. Common financial knowledge is commonly wrong!

Wait! Here’s the Missing Dollar

In case you missed it, I don’t want to leave you hanging on the case of the missing dollar! The phrase that throws the brain off kilter is “Add the $2 that the waiter kept, and that’s $29.” Actually, the two stolen dollars are part of the already-counted $27 cost of the sandwiches ($25 fairly charged plus the final $2 stolen). So the numbers to add are $27 plus the three dollars returned, which equals $30.