I have noticed an increasing amount of discussion regarding 401(k) loans. While almost all sources denounce this as a bad idea, I take issue with one of the supposed reasons why: double taxation. Suze Orman explains it her way:

Suze says when you put money in a 401(k), it goes in with pre-tax dollars—you add from your wages before the government takes any income tax out. When you take a loan out of your 401(k), you’ll usually have to pay it back in five years—with other money that has been taxed. Then, when you get older and you take money out of your 401(k) plan again, you’ll pay taxes again. “You have just volunteered for double taxation. Why would you want to do that?” Suze says. “Do not ever take a loan from a 401(k) plan.”

So does MSN Money:

Whether you repay the 401(k) loan out of your salary or from a bank account, those payments are all made back into the 401(k) with after-tax dollars. So, let’s say your monthly interest payment is $300 and you’re in the 28% tax bracket. You’ll have to make $416 in gross earnings to make the $300 payment. Then, when you retire and take withdrawals, you pay taxes yet again.

I see this double-taxation argument over and over… These quotes seem to suggest that you’ll lose something like 25% of your principal (or whatever your tax rate is) if you dare take out a 401(k) loan. Why are such trusted sources still spreading this misleading information?

Let’s say you want to borrow $10,000 from your 401(k) plan for a year. Your plan charges an interest rate of Prime + 1% = 6%, which you must pay back to yourself. That $10,000 was a pre-tax contribution, so you never paid income taxes on it. You take it all out, leaving yourself with $10,000 in cash. You haven’t paid any taxes on that $10,000. You leave it under your mattress, and a year later pay back the same $10,000 plus $600 in interest. Still haven’t paid taxes on the $10,000. When you eventually withdraw the money, then finally must you pay taxes. So what was the only thing taxed twice? The part attributable to the $600. Not the $10,000.

Question: Does it matter if it turns out someone took your original 10,000 and then replaced it without you knowing? The answer is no. As long as you pay back the $10,000, that is all that matters.

The only part that is taxed twice is the interest. And since you are paying yourself the interest, this small double-tax is really the only cost of doing this loan. Using the example above and assuming a 25% marginal tax bracket, that means you only got taxed an extra $150 on that $10,000 loan. This is the same as getting a regular loan with a 1.5% interest rate. Dealing purely with the effective interest rate paid and assuming you pay back the loan in a timely manner, a 401(k) loan is actually quite a good deal.

This leaves you with the real reasons not to take a 401(k) loan:

1. If you lose your job, you will have to repay the loan within 60 days or it will be considered an unqualified withdrawal. This means you lose any future tax advantages on that amount, and you will be subject to income tax plus a 10% penalty on the amount. This would boost your effective interest rate dramatically.
2. 401(k) funds are protected from creditors, even in the event of bankruptcy. If you borrowed money on a credit card and don’t pay it back, your credit score will tank but nobody will take money out of your hands. Just like how home equity loans can be dangerous because you are risking your home, unsecured debt is always better than secured debt. If something is so bad that you need to sacrifice your retirement savings, then bankruptcy may not be that far-fetched. Is this a one-time need, or are you just putting off the inevitable?
3. Some 401k loans do not allow new contributions if you have loan outstanding. So you could be losing out on some 401k matching contributions. This loss would also drive up the effective cost of a 401k loan.

Summary
401(k) loans can indeed offer you a very low effective interest rate given optimum conditions. However, there are important potential catches, enough that I would still personally take out an unsecured loan first if at all possible. Before taking on any debt, you should carefully examine your reasons for doing so. I think that only those with really bad credit (unable to get loan otherwise) and a short-term need with a quick payback schedule should take out a 401(k) loan.

Update: A lot of people still think double-taxation still occurs. As opposed to editing this post, I went ahead an made up a better example against the theory of double-taxation. Please check it out before making up your mind.

There’s nothing like going back to work on a Monday after a nice long holiday weekend to make you daydream about leaving the rat race behind. I would like to think that I am already on the path to early retirement, but I often like to hash out “The Plan”.

Ages 30-45: Live simply. Buy a home you can afford with a 15-year mortgage. Yes, you can get approved for a larger loan with a 30-year amortization. Homes are a huge expense, and just because someone will let you doesn’t mean you should take on that much debt. If you artificially restrict yourself to what you can afford with a 15-year amortization, you’ll end up with something that can easily be paid off early.

Yes, taking advantage of low fixed interest rate for 30-year mortgage can be argued to be advantageous on a mathematical level. But I am still enamored with the simplified cashflow situation once this huge monthly expense is taken away. Right now, a full 2/3rds of my monthly expenses go towards housing costs.*

Live frugally, try to save regularly for retirement, advance in career and get pay hikes, raise kids, still enjoy life, yada yada.

Ages 45-65: Find consulting or part-time work which will cover remaining expenses. Now, after 15 years, I will only have to pay for everything else – property taxes, car, utilities, food, etc. This should only run about $35,000 a year. Lower required expenses means lower required income, which means I pay a lot less in income taxes. Split between my wife and I, we’d only need to find jobs that pay about $25,000 gross each per year. (Numbers will need to be adjusted for inflation.)

This opens up so much flexibility. Despite my beach bum aspirations, I already know that you can’t spend all day at the beach. There are so many alternative business and job ideas that we would enjoy doing, but currently wouldn’t dream of doing because we make so much more money doing what we do now. Jobs with less hours, less commuting, less dealing with stupid people. The money that we have saved up in tax-deferred accounts should remain untouched, and we will still add as possible.

Ages 65+: Work as possible based on health, start taking Social Security, withdrawing from retirement accounts I know that most young people are skeptical of Social Security, but in reality I doubt it is going to go away for people with moderate incomes. It will simply be too critical a safety net in the age of self-funded retirements. I can see there being a phase-out for high income earners (it’d be very difficult to phase out based on net worth) – but again, without a mortgage, we won’t need a high income. The current average Social Security check is $1,000 per month, or $12,000 per year. If both of us received that, that would already cover 50% of our expenses.

These are all rough numbers and you never know what life will throw at you, but it’s nice to have goals. 😀

* No, you don’t necessarily need to buy a house to retire early. But it fits into my Plan nicely.

Excerpted from the interesting Early Retirement page of Philip Greenspun, a fellow who says he retired at age 37.

Ask a wage slave what he’d like to accomplish. Chances are the response will be something like “I’d start every day at the gym and work out for two hours until I was as buff as Brad Pitt. Then I’d practice the piano for three hours. I’d become fluent in Mandarin so that I could be prepared to understand the largest transformation of our time. I’d really learn how to handle a polo pony. I’d learn to fly a helicopter. I’d finish the screenplay that I’ve been writing and direct a production of it in HDTV.”

Why hasn’t he accomplished all of those things? “Because I’m chained to this desk 50 hours per week at this horrible [insurance|programming|government|administrative|whatever] job.

So he has no doubt that he would get all these things done if he didn’t have to work? “Absolutely none. If I didn’t have the job, I would be out there living the dream.”

Suppose that the guy cashes in his investments and does retire. What do we find? He is waking up at 9:30 am, surfing the Web, sorting out the cable TV bill, watching DVDs, talking about going to the gym, eating Doritos, and maybe accomplishing one of his stated goals.

Retirement forces you to stop thinking that it is your job that holds you back. For most people the depressing truth is that they aren’t that organized, disciplined, or motivated.

Could this be me? Nah, my goal is to be a beach bum and do nothing. 😉