(b)lines Ask the Experts – Double-Taxed on Plan Loans?

“I don’t believe she is “double-taxed” on the loan. Who is correct, me or the adviser?”  

Michael A. Webb, Vice President, Retirement Plan Services, Cammack LaRhette Consulting, answers:  

The Experts answer is: you are both correct! The loan is double-taxed in the sense that the loan repayments are made from a participant’s own after-tax income, and the collective sum of those payments is taxed again upon distribution of a participant’s account balance. However, when the participant initiates the loan, he/she actually receives a check for the principal amount of the loan that is tax-free. Thus the “double-taxation” of loan principal is negated by the fact that the participant received the loan proceeds on a tax-free basis; in essence, the participant is thus only taxed once on loan principal.      

Interest, however is another matter. Since the check issued to the participant includes only the principal amount of the loan, interest is indeed taxed twice, since it is paid back to a participant’s account from after-tax income, and is also taxed upon distribution. (Keep in mind, too, that if you took the loan from a third party such as a bank, you’d be repaying it with after-tax monies as well.  So one way to look at it is, that factor is neutral so far as taking a loan from your plan versus the bank.)   

The Experts can think of two more significant disadvantages of taking a loan: 

• Opportunity cost: loan proceeds only earn the interest rate on the loan until redeposited in the account. Though it is possible that the loan proceeds would have earned less money for the term of the repayment schedule if the funds had remained in the participant’s account, it is also quite possible that the funds could have earned a significantly greater amount than the interest rate. The opportunity to have earned a greater investment return is known as opportunity cost, and the effect, with compounding, can be quite significant, especially for younger borrowers who are many years removed from retirement. 
• Foregone savings cost: If the required repayments force a participant to reduce his/her elective salary deferrals to the plan, retirement savings will be impacted by the missing deferrals. The impact is again especially pronounced for younger borrowers, as well as those who participate in a matching plan and would no longer receive the maximum matching contribution due to the deferral reduction.  (Again, this factor is neutral if you are going to borrow from some other source anyway.)  

If you default on a plan loan, of course, you will also be subject to immediate taxation on the unpaid principal as a “deemed distribution” and possibly the early distribution excise tax if you are younger than age 59 ½.   

Of course, there are advantages to borrowing from a retirement plan as well (no credit check, the crediting of interest payments back to the borrower in the form of retirement account savings, etc.). Thus, a participant should perform a careful analysis of the advantages and disadvantages of taking a 403(b) plan loan prior to borrowing.    

Thank you for your question!