Thanks for checking out the blog today! This is my reply to a reader question to Robert Powell in his Retirement Daily segment for thestreet.com. Here are the question and answer below.
My wife and I took out a 401k loan to assist us with the cost of renovating our newly acquired home.
We’ve been repaying the loan back to the 401k but still have some ways to go. As you know, the loan repayments themselves are taxed and the eventual withdrawals get taxed as well, creating an unfavorable double taxation. Since we are already paying tax on the loan repayment, can we repay the loan back to a Roth IRA? This would allow us to avoid the withdrawal tax and the ability to grow our investments tax free!
We have searched online but could not find any information. Please help!
What a great question on a topic I think is commonly misunderstood and can easily result in misguided interpretations. There’s a lot to unpack here, so no need to delay!
The short answer to your question is no, you cannot borrow from a Traditional 401k and repay a Roth 401k. That would be pretty cool if you could, but it’s just not allowed. Loan repayments go back where they came from in the manner they came out.
Furthermore, when you borrow from a 401k, most plans dictate how those funds are to be withdrawn. For example, let’s say you have a 401k worth $100,000 and $50,000 of that is Traditional or pretax and $50,000 of it is Roth. Let’s assume you decide to take a loan from your 401k for $50,000. Your 401k plan document should provide guidance for how your withdrawal will come out.
It may state loans come out from pretax first or come out prorate from each area of tax status as a couple examples. You normally don’t get to make this election.
Next, I would like to clarify an erroneous statement you’ve made and discuss a bit.
There is not actually double taxation on the loan repayment. I see how you arrive at that conclusion, but it’s not. Hopefully I can help clear up the double taxation myth a bit.
Let’s dig in. I totally get how this can be misconstrued as double taxation. It can seem so obvious, but let me assure you it is not. Money goes in after tax and you have to pay taxes again when withdrawn. We need to think a bit more about what actually is happening.
Now, I understand your thinking that when you pay this back, it’s after tax and when you withdraw in the future you have to pay tax again; but you’re forgetting, the money you’re paying back, you’ve already received tax free from deposits and growth that were all tax free. THAT IS really the money you’re paying taxes on via your payback. It’s a lump sum you got tax free that you owe tax on. The 401k loan simply gives you the ability to defer the tax bill to align with your repayment schedule over a number of years, making it a more beneficial strategy from a purely tax view.
How about an illustration to help clarify? I didn’t come up with this, but it’s my version of the clearest example I’ve seen that helps illustrate. Let’s say you borrow $50,000 from your traditional 401k. Money went 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 have saved the money without paying taxes on it and got the loan without paying taxes on it. Now after some time period, a month, a year, a week, doesn’t matter, you dig the can, still with $50,000, and pay the loan back. Money in, money out, money back in, no additional taxes paid. It would be taxed then in retirement you took a withdrawal. So, no duplicated taxes here, right? You withdrew money tax free and paid it back tax free.
To think this is double taxed is to forget that the loan you received is money you haven’t consumed yet. If you view it on a consumption basis, that is to say the funds are taxed when they’re spent, you’re paying the tax on this as you earn it over the next few years, again delaying the tax liability.
If you didn’t have to pay back a 401k loan with after tax dollars, you’d be avoiding tax on that loan altogether and it would be a major loophole to get tax free distributions from 401ks.
I do think there’s a case to be made that the interest you repay is double taxed, but you could also argue you get a discount on it and the ability to add more to your 401k than limits allow. It depends on return & taxation assumptions which side you are on there.
This is where there’s some argument to be had. The money you pay back in interest, could arguably be double taxed. Let’s say you withdrew a $100 loan and paid it back over a number of years, so the total you paid back was $110. That $100 was money you spent (presumably when you took the loan) and payed taxes on the distribution since it was not previously taxed (via the payback to the account).
The $10 you paid in interest would be considered double taxed. As it is after tax money that is put into the account that will again be taxed when withdrawn. It’s not a replacement of a distribution or a new dollar you consumed.
To argue if this is double taxed or not is really an academic argument. It’s essentially debating which is greater, the pretax rate of return used in the time value of money or the interest rate paid on the loan. It gets messy quickly, so I’ll try to lay it out as simply as possible, though it may not be conceptually easy to think through.
Since you receive the loan, the interest is paid over time, so you are receiving benefits to that, which would be assigned some rate of return. If the rate of return on the time value is equal to that of the interest paid, there is no double taxation, since the price paid equaled the benefit received. Similarly, if the interest paid is greater than the rate of return, than that portion is double taxed and lastly, if the return on the money received is greater than the interest paid, not double taxed and allowed you to add more to your 401k than the legal limits.
If you’d like to discuss your financial situation or if a 401k loan might be right for you, Telos Financial would be glad to discuss a possible relationship with you. Contact us today to schedule a no cost or obligationintroductory meeting. Telos is a fee based, holistic financial planning firm serving Michigan’s high income and high net worth professionals, millennials, recent college graduates, and small business owners.
Thanks for reading the latest edition of Planning for your Purpose, Telos Financial’s blog, where I discuss different topics related to financial planning. CERTIFIED FINANCIAL PLANNER™ professional Dennis LaVoy is Plymouth, Michigan’s holistic financial advisor serving clients throughout the mitten as well as across the country.
The primary purpose of the blog is to introduce financial planning concepts and questions I receive from clients that I believe are important. I want to start discussions that will educate, benefit, and improve your financial life, ultimately, to help you focus on your telos!
Telos Financial is located in Plymouth, Michigan and focuses on serving young professionals and their families. Dennis LaVoy is a Certified Financial Planner® Designee and a Chartered Life Underwriter®. Dennis founded Telos Financial and to provide fiduciary financial services to families across Michigan including Plymouth, Canton, Ann Arbor, Detroit, and as well as all over the great United States of America.