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I have a question for my fellow humble members of this Forum.
I’ve often heard financial professionals discourage borrowing from a 401(k) plan, citing what they call a “double taxation” issue. The claim goes like this: when you repay your 401(k) loan, you use after-tax money, and then later, when you withdraw funds from your 401(k) in retirement, you’ll pay taxes again on that same money. Therefore, they say, you’re taxed twice.
While there are many valid pros and cons to taking a 401(k) loan, this particular “double tax” argument never quite sat right with me. For one, if you borrow from your 401(k) and instead of spending the money, use it to repay pay-off the loan quickly—before any meaningful interest accrues—there’s no additional tax involved.
Still, I recently heard the same claim again in a podcast, repeated confidently by another financial professional. That made me revisit my thinking—and I continue to believe this reasoning is flawed.
Here’s why: when you borrow from your pre-tax 401(k), the loan amount you receive is tax-free. You can spend it just like after-tax money, but without paying any tax upfront. If you had instead used money from your regular income or savings, that money would already have been taxed before you could spend it.
Let’s look at a simplified example.
Suppose someone needs to spend $100 they don’t have today. They have two options:
1. Borrow $100 from their 401(k), or
2. Wait until they earn and save $100 from their paycheck.
To keep things simple, let’s assume their marginal tax rate is 20%, the 401(k) loan is interest-free, and the 401(k) investments earn zero return.
Scenario 1 (401(k) loan):
They borrow $100 from the 401(k) and spend it. Later, they earn $125, pay $25 in taxes (20%), and use the remaining $100 of after-tax income to repay the 401(k) loan.
Scenario 2 (No loan):
They don’t touch the 401(k). They still need to earn $125, pay $25 in taxes, and use the $100 of after-tax income for the same purchase.
In both cases, the person ends up paying the same amount of tax. The key difference is simply timing: the 401(k) loan gave them access to pre-tax dollars earlier, which they later repaid using after-tax income – just like they would have used to make the purchase anyway.
So, the “double taxation” argument doesn’t really hold up for the principal amount. While the repayment does use after-tax money, the loan itself was made with pre-tax funds, and that offsets the effect. You’re not taxed twice on the same dollars, except perhaps the interest portion which has to be paid using after-tax money and will be taxed again. But that’s a minor amount, plus you are paying interest to yourself, which makes the loan effectively interest-free.
That said, 401(k) loans can have real drawbacks depending on the timing, like losing potential investment growth while the money is out of the market, liquidating funds when market is down, and the risk of triggering taxes and penalties if you leave your job before fully repaying the loan. Those are valid concerns. But the “double tax” rationale isn’t one of them.
What do you think—does this reasoning make sense to you, or is there something I’m missing?
Thanks in advance!
“For one, if you borrow from your 401(k) and instead of spending the money, use it to repay pay-off the loan quickly”.
I have to ask, if they didn’t spend the money why take the loan?
Sorry I was unclear. That example is to illustrate the misconception, not a real-life scenario.
Take it from a 401k Subject Matter Expert: Loan interest is never double-taxed.
Let’s start at a different point. When you need liquidity, and you don’t have cash lying around, you either borrow from a commercial source or from your 401k. If you borrow from a commercial source, the interest you pay may or may not be tax deductible, depending on the purpose. You certainly don’t get that interest back at a later date.
You won’t borrow from the 401k if the commercial loan provides a better value. And, you won’t borrow commercially if the 401k offers a better value.
In fact, given all of the credit card debt in America, payday loans, etc., there are many studies that suggest Americans should borrow more from their 401k to retire those debts.
So, think of your 401k as the Bank of Sanjib:
Done right, repaid in full, a plan loan will improve both your household wealth and your retirement preparation.
First, when you take a loan, it is secured with assets in your 401k. That means that the assets are converted from whatever investment you had into a fixed income investment, like a bond (same as a bank). The fixed income rate of return is the interest rate you pay.
So, first step. Because the principal never leaves the plan, it becomes a fixed income investment, you should examine your asset allocation after the loan is made to ensure you haven’t deviated from your investment strategy.
Second, the interest you pay on your 401k loan may be tax deductible. If the loan is secured with a home mortgage (where interest is otherwise deductible), or starting in 2025 through 2028, new tax code section 6055AA may allow for an “above the line” tax deduction of interest on a loan secured by a lein on a qualified passenger vehicle.
Third, unlike the bank, where interest you pay on a bank loan is always taxable income, the taxation of the interest you pay can be either taxable monies when distributed or tax free:
But to answer your initial question, the interest isn’t double taxed.
The interest you pay on the loan is treated the same as it would be for any other loan – it is either tax deductible or it isn’t.
The interest you receive at distribution is not the same interest. It is treated the same as any other dollar of interest you earned on your 401k investments.
The challenge is that most plan sponsors and their recordkeepers think of 401k loans as leakage. Most recordkeepers haven’t updated their processing to 21st Century functionality – they still require payroll deduction, which is so 20th Century.
Most everyone reading this post already pays at least one bill electronically.
Why not your 401k loans?
#7 is the sticking point. My experience was that many, if not most participants could not afford to both make the loan payment and continue the contributions, at least not at the same level.
Thanks, RDQ. I agree that “credit”, despite being a powerful tool, can also be very dangerous if not used properly. This logic applies to not just 401K loan, but to any form of loan taken to pay for stuff with borrowed money.
If a person who borrowed from 401K cannot afford to continue both regular contributions and loan repayments, the same person won’t be able to continue with regular 401K contributions and payments for any loan repayments (i.e., even when the person didn’t take 401K loan, but borrowed elsewhere). There’s nothing unique to 401K loan here – the logic applies to any loan, including the most common form of loan which is paying with credit card.
The attribute unique to 401K loan is that job loss requires early pay-off (to avoid taxes and penalties), whereas most other loans won’t lead to an unexpected “early pay-off” situation.
Assuming that the borrower can use the loan responsibly without affecting future contributions, the part that most might miss is #6 – To maintain the overall asset allocation across all investments during the life of the loan. This, in my opinion, is a tricky part that’s easy to overlook.
The thing is it is too easy to get the 401k loan. Participants see it as borrowing from themselves when as you know they are borrowing from the plan trust.
Thank you so much for the detailed explanation, BenefitJack. I really appreciate your taking the time to walk through this.
I agree with your general premise that when used correctly and when there is a genuine need to take a loan, borrowing from 401K works very well for a disciplined investor with steady job, as long as the asset-allocation can be maintained in the overall investment portfolio (i.e., there is no market timing risk involved, requiring one to liquidate stock investments during downturn).
I’m a bit lost on your comment: “Second, the interest you pay on your 401k loan may be tax deductible.” As far as I know, 401K loan interest isn’t tax deductible. If you have it handy, would you mind giving some reference (e.g. IRS guidelines or official documentation) that explains when 401K loan interest can be tax-deductible?
Also, if the loan is from a 401K ROTH, then I presume that the principal and interest both will be deposited back to the 401K ROTH, and therefore there is no double-tax on the interest on a 401K ROTH loan. But I’m unclear how the interest you pay on a regular (pretax) 401K loan avoids double taxation. Are you saying that when the loan is repaid, the principal is added to the tax-deferred portion of the 401K and the interest is added in the after-tax portion of the 401K? If not, then the interest will be taxed on distribution – which leads to the double-taxation issue. I might be missing something here, and I’d appreciate if you shed some light on my doubt. Thanks in advance, BenefitJack.
Irrespective of the double-taxation issue, I do see 401K loans as financially better compared to commercially available alternatives, because effectively it becomes a zero-interest loan (except the small double-tax component).
I like your post. My thinking to the answer to your question “Why not your 401k loans?” is that the third party administrator (TPA) or plan sponsor may have an expectation that some borrowing from their 401(k) plan balance will fail to make voluntary electronic payments in a timely manner and create an event that needs to be cured by the end of the quarter or an actual default causing a taxable and maybe a premature distribution event with the accompanying taxes and penalties.
The TPA may think the certainty of receiving the scheduled loan payment being paid via net payroll deduction before the participant gets their net pay may reduce the likelihood of a loan violation event that causes a default. What are your thoughts BenefitJack on why no changes in repayment options?
For the last 15 years, the interest rate on plan loans has exceeded the interest rate on almost all bond investments.
So, assuming you rebalance your account to the appropriate allocation of assets, the interest you paid on your plan loan was higher than the interest rate on other bond investments offered by your plan – improving your retirement preparation.
And, assuming that the plan loan had an interest rate less than the rate you would have paid on a commercial loan (if the commercial loan rate was lower, you would have chosen that, right?), that means that you paid less interest on the liquidity you needed – improving your household wealth.
I agree.
I have a question about this statement: “if the commercial loan rate was lower, you would have chosen that, right?“, I’m not so sure about that. Here’s why.
The effective rate on the 401K loan is almost 0%, irrespective of the posted interest rate of the loan (since the interest is eventually coming back to the borrower after taxes). So, even if the 401K interest is 6% and a commercial loan is 4%, isn’t the 401K loan still better, despite the higher rate of interest?
Thanks for your valuable insight.
Aren’t you missing the part where you later take a taxable distribution of the $100 from the 401k? Now you pay tax again on the $100 that you repaid with after-tax money.
Thanks Julie. No, and that’s the source of misconception.
Hope this clarifies.
Great to see a post from you, Sanjib. Your example is clear. The others must be referring to taxes on interest.
Would love to sync up with you some time!
Thank you, David. Yes, let’s please do that.
Sanjib, I agree with your assessment. Christine Benz wrote an article some years ago that validates your assessment, and also addresses some of the other concerns you discuss.
I have read the Benz article, thanks for the link. I think that article is a worthwhile read.
Some specific Roth 401(k) plans allow participant loans, but I wonder if those participants typically choosing to make Roth contributions would be likely to borrow from a 401(k). Plans allowing loans must require a market rate to be charged, often a prime rate plus a fixed percentage such as the current prime rate plus 1%. Loans often also have a loan origination fee, like $100, that is paid at loan inception to the third party administrator, and not to the participant account balance.
I believe I saw only one such loan from a Roth 401(k) plan made in my pre-retirement years.
Thank you for pointing to the M* piece. It’s very good and also busts the “double tax” myth.
Sanjib, I think that you are correct on all counts. My main problem with taking a loan from a 401(k) is, as you stated, the possibility that you leave your job, and are unable to pay back the loan. That scenario, of course, incurs tax, plus the penalty. I have witnessed this play out for dozens of people. I would add that in this situation, there is rarely enough withheld for taxes, causing much consternation come tax time.
Thank you, Dan. I agree with you. I think it’s a tool that must be used with much caution instead of casually just because it’s available.
Sanjib,
Your analysis is spot on and you state it well. I came to the same conclusions 20+ years ago when I used 401k loans to finance our son’s college education. I am convinced that the press and some financial advisors advise against using this tool based on their assumptions that people will not pay back these 401k loans, or that they will stop or reduce making 401k contributions while a 401k loan is outstanding, or that they will take out 401k loans for reasons other than funding necessary expenses. If you avoid these pitfalls and the interest you must pay on the 401k loan is relatively attractive, then I don’t think there is a problem with using 401k loans to finance necessary expenses.
Thanks, William. I had once taken 401K loan myself for a short period. I found it a good option compared to other choices I had at that time. As you say, for someone who isn’t confident of being disciplined about paying back the loan, any loan – including from 401K – is dangerous.
If I borrow from the 401k, I am paying interest to the trust which is credited to my account. Thus I am paying myself interest with after tax money and later I am taxed on the interest I paid to myself as ordinary income.
Outside the plan what I earn on the funds is not coming from me.
Maybe that’s what they are talking about.
Thanks, RDQ. Yes, the double-tax apply for the interest portion only. But that should be a much smaller amount and also should be offset by the fact that it’s virtually a 0% interest loan. But I’m not sure if they were talking about the interest part. It felt as if they thought the principal is being taxed twice.
There are minimum percentages that must be applied to grant the loan from the 401k. It may be below market, but not virtually 0%. The typical interest rate on a 401(k) loan is often set at the current prime rate plus 1% or 2%
Following are the headline provision requirements for plan loans under ERISA –
In general. Section 408(b)(1) of ERISA exempts from the prohibitions of section 406(a), 406(b)(1) and 406(b)(2) loans by a plan to parties in interest who are participants or beneficiaries of the plan, provided that such loans:
(i) Are available to all such participants and beneficiaries on a reasonably equivalent basis;
(ii) Are not made available to highly compensated employees, officers or shareholders in an amount greater than the amount made available to other employees;
(iii) Are made in accordance with specific provisions regarding such loans set forth in the plan;
(iv) Bear a reasonable rate of interest; and
(v) Are adequately secured.
Plans will typically have additional plan sponsor participant loan requirements that may be found in the Summary Plan Description (SPD) which are formally in the plan adoption agreement provisions.
Participants should receive a SPD which must under ERISA rules be provided to participants every five years if the plan has been modified, or every 10 years if there have been no changes. Initial distribution of the SPD is also required within 90 days of a participant becoming covered or within 120 days for a new plan. Material modifications must also be communicated annually if there are changes to a plan. Many plan providers just issue a new SPD to participants upon initial participation in a plan and annually thereafter with a goal of avoiding a plan failure to meet this particular ERISA requirement.
All advisors do not give good advice. Clearly this was an example of that.
Thanks, Mike. The professionals involved here (about this issue) are otherwise genuine and client focused. I think they probably heard this “half-truth” somewhere else and didn’t take the time to validate it. I suppose an inadvertent misconception on their part.
The only thing I can say in defense of those professionals, is that their convoluted double tax argument might persuade someone to not take the loan.
That’s a good one :). Prevent unnecessary borrowing that can backfire.
It’s pretty obvious that no one is taxed twice. The intent is that 401k withdrawals are taxed once and they are.
The only issue is in cashflow terms when it comes to paying back when in a later period one might need to earn taxed money to pay the 401k debt back. Or one might receive a gift of the necessary amount. Best just to think of a 401k loan as any other form of debt.
Thanks, bbbobbins.
I really enjoyed reading your analysis. Although I’m not a US citizen and 401(k) plans are irrelevant to me, I appreciate critical thinking and sound reasoning, and your post exemplifies both.Your reasoning appears very sound. The “double taxation” argument stops halfway through—it counts the after-tax repayment but ignores the tax-free spending that preceded it. Your comparison effectively demonstrates why this claim falls apart. The math is straightforward once you account for both sides: tax-free disbursement and after-tax repayment. What’s impressive is that you didn’t accept conventional wisdom even after hearing it from multiple professionals. Well done for thinking critically rather than accepting repeated talking points at face value.
Thank you for validating the reasoning, Mark. Much appreciated.