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In a recent column I cautioned my readers against cashing in or taking loans from 401(k) or other types of retirement accounts. One of the problems with taking a loan, I said, is the matter of double taxation. And those two words caused a tsunami to wash up on my desk. Some of you just did not understand, while others suggested I am all wrong and don’t know what I’m talking about. So I’m going to give this matter of double taxation another shot today, giving full forgiveness in advance for readers who doubted me. The biggest benefit of a 401(k) or other type of IRS sanctioned retirement account is that you get to invest pre-tax dollars. That means if you earn a dollar you can invest the entire dollar into your plan. So let’s say your weekly wage is $1,000 and you are set up to invest $100 into your 401(k) plan. The $100 is deducted and sent to your plan. Now your wage is reduced to $900. Your taxes and other withholding are based upon $900 not the $1,000 you actually earned. Let’s say for illustration purposes that your after-tax, or take-home pay, is $720 per week, even though you earned $1,000. Are you still with me? Good. Let’s proceed. You’ve been on the job for a long time and your 401(k) has grown nicely. You have $10,000 in credit-card debt at 14 percent and it is really bugging you. Your payment is high and it appears that you can’t get out of debt. So you borrow $10,000 from your 401(k), repayable at 6 percent interest over five years with monthly payments of $194 that are automatically deducted from your paycheck. Okay, now get ready, because here comes the first taxation. It is not on the $10,000 that you borrowed, but it’s on the money you use to pay it back. The $194 payment each month is taken from your after-tax dollars—also known as your take-home pay. This means that in order to actually possess $194 in after-tax dollars for your loan payment each month you will have to earn $248, assuming you are in the 28 percent tax bracket. This is the first taxation. Suppose that everything works out and you stay on the job for the full five years so that you pay back the entire $10,000 in after-tax dollars. You will have had to earn $13,890 gross to net the $10,000 required to repay the loan. You don’t get to repay loans with before tax dollars. Here comes the second taxation: When you withdraw that already taxed $10,000 during retirement after you turn 59.5, you will pay taxes on it again as you will on all the money in your 401(k) account. So if you are still in the 28 percent tax bracket you’ll pay another $2,800 in taxes on that $10,000, for a total of $6,690 in taxes—or 48 percent tax—on that original $13,890 you had to earn to repay the loan. That’s the result of double taxation. Of course the IRS is going to love you to pieces for being so generous, but it’s a really bad deal for you. Double taxation is only one of the pitfalls of borrowing from a retirement account. And that’s why my best advice is to see your retirement accounts as out of reach for now. Don’t even think about cashing them in or taking loans from them. It’s just too expensive. ______________________________________________________
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©Copyright 2008 Mary Hunt |
