 401(k)
loan payments are taxing
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 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
 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."
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