People seem very confused about 401(k) loans

February 2018

While deciding how much to contribute to my 401(k) this year, I looked into how easy it would be to access the funds in an emergency. (I was worried that maxing out my contribution, plus trying to meet my donation goal, would leave me with too little in liquid savings.)

The most obvious way to do this is by withdrawing the money. You’re allowed to do this before you retire, but you have to pay tax on the withdrawal as ordinary income plus a 10% extra fee. This is not great, since it both costs a lot, and also effectively reduces your investment limit.

There’s another thing you can do, which is to take out a loan with the 401(k) as collateral. However, much of the Internet financial advice industry seems to believe that by some sorcery this causes you to pay extra taxes (one, two from the first page of Google results).

When you repay your 401k loan, you do so with after-tax dollars… [and] when you eventually retire and begin withdrawing money from your 401k in retirement, all of your 401k money–regular contributions and loan repayments–is taxed as ordinary income. That means your loan repayments will be taxed twice: first at repayment while you’re working, and once again at retirement.

This is wrong because your 401k loan repayment isn’t a contribution–that is, it doesn’t change the net assets of your 401k. Or alternately, if you want to count the 401k loan as a contribution, you should count the loan origination as a tax-free distribution, negating the impact of the extra taxes on the contribution.

If you’re still unsure about that argument, you could make yourself a spreadsheet like this one comparing a 401k loan to a 3rd-party loan, which should make it immediately obvious that the two are equivalent. (Actually, in real life a 401k loan is usually cheaper, because you pay the loan “interest” to your own retirement, rather than a third party!)

This isn’t to say that 401k loans are a great idea. In particular, if you leave your job the entire balance becomes due immediately, and if you default you’ll have to pay income tax on the loan plus a 10% early withdrawal penalty. So unless you have a very stable job it’s probably not a good first-line source of credit. But, if you’re worried that maxing out your 401k would leave you with too little liquid savings, the prospect of an inexpensive 401k loan is a good reason to worry less about that.

The moral of the story is that apparently many “certified retirement advisers” can’t be bothered to count money correctly, or even to get Excel to count money correctly for them. Perhaps more surprisingly, trendy Silicon Valley Startups can’t be bothered either:

The biggest issue for employees is that they would be paying loans back with after-tax dollars, which which [sic] some tax experts argue is effectively double taxation, as they pay taxes again once the money is withdrawn from the 401(k). The government tries to dissuade people from dipping into their nest eggs, just as they try to incentivize contributions into a 401(k).

I actually emailed Captain401’s customer support about this since they’re my employer’s 401k administrator. The current wording is what they changed it to after admitting that my analysis was correct; previously they said “is effectively double taxation” instead of the un-sourced “which which some tax experts argue” weasel words.

Of course, as a certified expert on tax experts, I can tell you that anyone spreading double taxation FUD is ipso facto not a tax expert, but Captain401 doesn’t seem to appreciate my excellent credentials.

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Jess Riedel

It is mind-boggling how poorly this stuff is understood. The number of decisions that are reached from first-principles reasoning, rather than “do what other people are doing,” is vanishingly small…