November 14, 2012

Suze Orman is WRONG about 401k loan Double Taxation

In a recent episode of her show Suze Orman doubled down on her claim that 401k loans are subject to double taxation.  She said that many people had written to her to tell her she is wrong but she arrogantly brushed it off and declared that she's right and everyone else is wrong.   In her stubborn refusal to admit any wrong Suze even condescendingly assumes that anyone arguing against her is just trying to rationalize their own use of 401k loans.  

I'm here to tell you that  Suze is wrong about this pure and simple.   I do not have a 401k loan nor do I plan to take out a 401k loan.

You are not subject to additional taxes and your tax bill does not increase as the result of a 401k loan.

You are not subject to additional taxes and your tax bill does not increase as the result of a 401k loan.

I said that twice cause its important.

There are various explanations on the web about why Suze is wrong and there is no double taxation.  

Note : I'm not saying 401k loans are a good idea in general.  Usually you should avoid taking a 401k loan.    The point I'm making is simply that the 401k loan does not amount to double taxation.  


I think the best way to illustrate how there really isn't any double taxation is to compare the actual taxes paid on a 401k with and without a loan.   If you have double taxation from the 401k  loan then your taxes should be higher right?   It isn't.

Lets look at 2 scenarios:

4% loan rate and 8% investment growth

Let it sit -
I have $25000 in my 401k today.   I do nothing at all and let that money sit in my 401k for the next 25 years.  With annual compound growth of 8% the balance will grow to $171,211.   In 25 years lets say that my marginal tax rate is 20%.   I pay taxes of $34,242.

Take a loan-
 I have $25,000 in my 401k.  I decide to take out a loan for $10,000.   I pay 4% interest and pay back the principal in 1 year.  The other $15,000 sits in the 401k and makes 8% interest for that year.  At the end of the year I've got $15000 x 108% + $10,000 x 104% = $26,600.   After 24 more years of 8% compound annual growth my balance is now $168,675.   In 25 years my marginal rate is 20% so I pay taxes of $33,735.

If I let my money sit it grows at 8% and I end up with $171,211 and a tax bill of $34,242.   If I take out a loan my money grows slightly slower and I lose compound growth after that so I only get $168,675 and a tax bill of $33,735.   In this fairly realistic example I actually end up paying lower taxes in the end due to the 401k loan, simply because borrowing away from my retirement under cuts its growth.

4% loan rate and 4% investment growth

Lets look at another example and assume that the money grows at 4% so its equal to the 401k loan rate.

Lets say I've got $20,000 in my 401k and I'm 55 years old.   I let it sit and it grows at 4% a year.  In 10 years I retire and I've got $29,604.

Instead lets say I take out a $10,000 loan and pay it off at the 4% rate.   At the end of 1 year I pay off the whole loan and then end up with $20,800.   Then after 9 more years I have the same $29,604 balance.  

In both of these cases my actual tax bill is going to be the exact same amount since the 401k balance is exactly the same and will be subject to the same tax.

Why is Suze wrong?

Apparently Suze is just playing a stupid shell game with your dollars.   She claims that since you repay your 401k loan with after tax dollars and then have to pay tax on the 401k after you withdrawal the money that this amounts to double taxation.    But theres a couple big flaws with this logic.  
#1 you have to pay income tax on your income whether or not you have a 401k loan so that money is already taxed no matter.   401k loans don't cause income taxes.
#2 she appears to ignore or at least doesn't mention the loan withdrawal you receive from the 401k.  when you take out a loan you are handed money which has no taxes on it.   So if I borrow $10,000 then immediately turn around and repay that $10,000 then its all untaxed money.   The only out of pocket money here is the interest you pay.  

I'm not the first to write about this and I probably won't be the last as long as Suze stubbornly obstinately sticks to her claim.

Heres at least two other people pointing out how she's wrong: 

The financial buff wrote :  401k Loan Double Taxation Myth
MyMoneyBlog covers it with Double Taxation and the Real Reasons 401(k) Loans Are Bad
and Better Example Against Double-Taxation Of 401(k) Loans




Plus of course the numerous people who apparently wasted their time to send her emails to point out she's wrong.  


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4 comments:

  1. I agree with you. Just think about the tax loop hole if one were alowed to pay back a loan pretax.
    Here is a read. go to section 3.2
    www.federalreserve.gov/pubs/feds/2008/200842/200842pap.pdf

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  2. Wow, this is a tricky one, sorry I don't have time to log in. What you are saying, I think, is that the appropriate comparison is between A) spending the tax-free 401k loan in year 1, and then repaying it with after-tax dollars in year 2; and B) waiting until Year 2 and spending the amount of the loan+interest from after-tax income. Option B is better only by the amount of interest, and worse in terms of opportunity cost, rising tax rates (they will never go down again), etc.
    Tricky, but you are correct. Thanks!

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  3. NO, Suze is correct. What you are all forgetting is that the money you use to REPAY the 401k loan is AFTER-TAX money. You hae already been taxed on it before the payroll deduction is made to repay it- (1st taxation). Then, the money sits and grown in your 401k until you withdraw it, whereupon you pay tax on the money you withdraw (2nd taxation). Therefore, the money you repaid is DOUBLE-TAXED.

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  4. The money you pull out of the 401k as a loan is UNTAXED. When you put that money back in it hasn't been taxed so it is also UNTAXED. There is no net change in taxation from a 401k loan.

    Jim

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