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Dr. Don Taylor, CFA, Bankrate.com advice columnist401(k) loan payments are taxing

Dear Dr. Don,
I save my allotted 15 percent for my IRA account at work. My daughter starting school and a son getting married (a promised gift) has left me cash strapped! I want to borrow about $15,000 from my IRA, seeing that I am not making a bundle in that account, to help offset costs and save on credit card expense. Why is it I pay off the loan with after-tax dollars versus pretax dollars?

The money I borrowed wasn't taxed, at least until I do not pay it back or default on the loan where I assume a 10-percent penalty and have to claim on my taxes. This doesn't seem right. My account will build back up to the amount I borrowed, but I will be paying back a lot more in after-tax dollars only to pay tax again when I start to withdraw the money when I retire. I think I shouldn't have to pay taxes on this $15,000. 

Help! This seems like double taxation to me because after-tax dollars on $15,000 with no dependents is like 20 percent. Are other people aware of this, and is my company correct in its approach to these loan payments?
-- Tom Tumult

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Dear Tom,
Since you can't borrow money from an IRA account, I'll make the short leap to where you want to borrow from your 401(k) account. As you point out, you don't pay the penalty tax or income taxes on the loaned funds unless the loan isn't repaid. Since most employers, like yours, set up automatic loan payments, the tax issue only rears its ugly head if you leave that job. Then the loan immediately comes due and, if you can't pay it off, is treated as a distribution from the 401(k) account.

Plans that have loan provisions typically allow you to borrow up to half your vested account balance, but the loan can't exceed $50,000. The loan has to be repaid, with interest, in five years, although longer loan terms might be available when using the loan proceeds for the down payment on your primary residence. 

I understand your frustration in paying back the 401(k) loan with after-tax dollars, but that's the way it works. Otherwise you'd be getting two tax deferrals, one for the original 401(k) contributions and one for the loan repayments.

Reducing your contributions to the 401(k) plan can free up some funds in the short term. If your company matches a portion of your contributions, you'll want to at least contribute up to the limit of the match. A home equity loan or line of credit may be an alternative to borrowing from the 401(k) plan, and student loans can be a viable alternative to the plan loan. 

To ask a question of Dr. Don, go to the "Ask the Experts" page, and select one of these topics: "financing a home," "Saving & investing" or "money."

Bankrate.com's corrections policy -- Posted: Aug. 18, 2006
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