Posted by Maria T. Hurd, CPA
Pre-tax contributions to a 401(k) or 403(b) plan are not taxed when made to the plan but are taxed when the participant receives a distribution of the contributions. This means that a participant receives a tax benefit in the form of a tax deferral when the contributions are made to the plan. Such deferral continues, along with the deferral on earnings until the contributions and earnings, are distributed. Once the pre-tax contribution is made, nobody can take away the benefit of that tax deferral, not even a participant loan that is repaid with after-tax dollars.
Service providers and advisors who claim that participant loan repayments result in double taxation do not see the full picture, so they continue to spread an erroneous urban legend.
If a plan participant needs a loan and takes a loan from the plan, or from a bank, or from a relative, the loan repayment is always made with after-tax dollars. Please note that loan proceeds are generally not taxable. If the loan repayments to a retirement plan were made with pre-tax dollars, the participant would effectively get TWO tax deductions or tax deferrals for only one distribution that will be taxable. The IRS does not offer “Two for the Price of One” sales that would entitle a person to two separate tax-deferred contributions to a plan in exchange for only ONE taxable distribution at the end. Thus, it is an error in logic to say that the funds that are distributed to the participant from a retirement plan upon termination or retirement at a later date are anything but the funds attributable to the original contribution. A participant loan is a separate and tax-neutral transaction.
Participant loans are paid back with the same funds and in the same fashion as the participant would pay a loan from a bank, or anyone else, with after tax dollars. These repayment dollars would be taxed, as they should be, in the course of the participant’s financing endeavors. Those funds repay the loan and should not be viewed as the funds that are later distributed from the retirement plan. The terminating or retirement distribution at a later date is attributable to the original tax-deferred deposit. I am, by no means, recommending plan loans as the best form of financing in every case. As everything in life, it depends. In a declining market, participant loan repayments would guarantee a fixed rate of return and provide an opportunity for the participant to buy in a low market. In cases where the participant has no other source of financing available, it provides the opportunity to get needed financing and pay oneself interest, as opposed to a bank. In this case, the interest payments benefit the borrower, instead of a third-party lender. If the loan replaces a portion of the portfolio invested in fixed-income products, then the opportunity cost or gain is the result of the difference in interest rates.
The fact that the principal payments do not result in double taxation is clear. To counteract the argument that the interest the participant pays himself or herself is double taxed, we must take into account the fungibility of money. Paying the same interest to a financial institution would mean that the participant would never have seen those dollars again. In effect, the interest payments to the plan replace the investment earnings that those dollars would have earned in the plan had there been no loan, that is, earnings that would have been taxed when distributed. In this case, the source of the funds that make up the investment earnings is irrelevant. In the end, the key question to answer is: Does a participant that takes out a plan loan pay more taxes than if he/she had taken out a loan from another source?. The answer is clearly, NO. To think it does is an error in logic that perpetuates a misguided urban legend because, objectively, the math shows that participant loans do not result in double taxation.