Are retirement loans double taxed?
The Answer is Yes and No
Some say yes. The loan is paid back with after-tax dollars. That means the loan payments are taxed when going back into the plan. Then that money is taxed again when withdrawn in retirement. In other words, the loans do not reduce the person’s taxable income in the years the loan is repaid, and they do not give the retirement account owner a basis. Then the money will be income taxed when withdrawn later, hopefully in retirement. Thus, these dollars are taxed twice. That sounds correct.
However, this analysis does not consider what had already happened to the dollars before they became the principal on the retirement loan. The dollars used as principal on a traditional retirement plan loan can only come from tax deductible contributions or earnings on tax deductible contributions. Either way, the dollars that became the principal on the retirement plan loan had never been income taxed. Then this loan money comes out tax-free as part of a retirement plan loan. So far, these dollars have never been income taxed for the first time. When the retirement plan loan principal is repaid the never income taxed money would be returned to the retirement plan. When this money is eventually withdrawn it will be taxed. So, the final result is the dollars for the retirement loan principal repayments are not taxed going into the retirement plan then income taxed when withdrawn. This is single taxation, not double taxation.
While the principal portion of a traditional plan loan payment is not double taxed, can the same thing be said of the interest on a retirement plan loan? In a word, no. The interest portion of a retirement plan loan has no prior connection to the retirement account. It is new money in the retirement account that was never deductible and it does not get a basis. Thus, it is truly an after-tax contribution, but the law does not give it a basis. Thus, the interest on a traditional retirement plan loan payment is income taxed (by not being deducted) when it goes into the retirement plan and then also income taxed later when withdrawn. Those dollars, but not the earnings on those dollars, are double taxed.
Thus, the final answer on whether or not a retirement plan loan is double taxed is that the principal repaid is not double taxed, but the interest payments are double taxed. This is where most analysis stops. But, what percentage of the original retirement plan loan is double taxed? Here is the interest paid on five year loans on $10,000 and their corresponding percentages.
2 % Loan 4% Loan 6% Loan 8% Loan 10% Loan
$517 $992 $1,600 $2,166 $2,748
5.17% 9.92% 16% 21.67% 27.48%
Thus, there is some truth in believing that traditional retirement plan loans are double taxed. The higher the interest rate on the loan, the more it is double taxed. However, if the prime rate is around 7% and the loan adds one percentage point, then a little over a fifth of the total loan payments are double taxed when withdrawn.
Okay, around a fifth of an 8% retirement plan loan is double taxed. How bad is that? While it depends on the tax rate, the first half of double taxation is normal. Thus, only the second time something is taxed is out of the ordinary. However, the second time the interest on the loan is taxed will probably be in retirement. Many people that will be in a lower rate than when they were working. Still, if the person is in the 22% tax rate while working and also during retirement, then approximately a fifth of a fifth of the loan principal would go to the federal government. Technically, it would be 22% of 22%, so 4.8%. That is about 5% of the original loan being lost to the government. In other words, the government will get an excess tax of around 5% of the retirement loan extra when the person pulls the money out when it is withdrawn. What if the retirement loan was at 6% and the retiree was in the 22% MTB? The actual bill would be about 3.5% of the loan. The interest would be 16% of the loan, then that would be taxed 22% so the actual tax bill would be 3.5% of the original loan.
What about the Social Security tax torpedo? That is when the receipt of another dollar of taxable income results in more of a person’s Social Security becoming taxable. The highest percentage of Social Security benefits being taxable is 85%. That means to estimate the maximum double taxation bill for a retirement plan loan would be around 6.5% for a 6% retirement plan loan and about 8.8% for an 8% retirement plan loan for someone in the 22% tax bracket in retirement.
A 6% retirement plan loan results in 16% of the loan being double taxed. If that 16% results in another $0.85 of Social Security being taxed per loan dollar, then the actual tax burden of 22% would be on 6.5% of the loan. This is 1 × 0.16 × 1.85 × .22 = 6.5% of the retirement plan loan actually going to the government in income taxes for someone in the 22% MTB when they retire.
An 8% retirement plan loan results in 21.67% of the loan being double taxed. If that 21.67% results in another $0.85 of Social Security being taxed per dollar, then the actual tax burden of 22% would be on 8.82% of the loan. This is 1 × 0.22 × 1.85 × .22 = 8.825% of the retirement plan loan actually going to the government in income taxes for someone in the 22% MTB when they retire.
Thus, as a rule of thumb, the double taxation when the interest payments for a retirement plan loan are ultimately taxed when withdrawn for someone in the 22% MTB at retirement would be between 3.5%-6.5% for a 6% loan, and 4.8%-8.8% for an 8% retirement loan. The numbers would be lower for thus in the 12% MTB and below
While paying any taxes feels like a burden at the time, if the loan was taken out and repaid years before retirement, then inflation would decrease the real cost of the interest being taxed a second time. For example, a 3% inflation rate for 20 years would mean $1 paid to the government in 20 years would have a current value of about 55 cents. That makes the prospect of being double taxed feel a bit less daunting. But should it? Inflation really means many more dollars will be needed in retirement. That means it is harder and harder to fund an appropriate retirement. In all, the interest on the retirement plan loan being double taxed is not a major problem for most, but why face any more hurdles in retirement?
What can be done to reduce this issue? If someone knows they will lose some of their retirement plan loan amount to unfair double taxation, they could address it by repaying their retirement plan loan more quickly. This would reduce the interest payments. This would also pay off the loan more quickly and return the money to their normal investments allocation. It would also lower the amount they would need to repay if they left the employer before the loan was repaid.
