The claim that 401(k) loans are subject to double taxation is a persistent myth that has been perpetuated by many personal finance commenters. They point to the fact that 401(k) loans are repaid with after-tax dollars and that the repaid retirement assets will be taxed again upon distribution. It sounds plausible but upon closer inspection, this is not at all the case. Well, not exactly; only 401(k) loan interest payments are subject to double taxation which as we illustrate below, may have only a marginal impact.
Loan withdrawals from your 401(k) are not taxed like other withdrawals of tax-deferred dollars. You will not receive a Form 1099-R unless you default on your loan repayments. Loan proceeds will be used to pay for goods & services that would otherwise be paid for with after-tax dollars. Loan proceeds receive the same treatment as any other after-tax source of cash. The argument that loan payments should come from pre-tax deductions rather than after-tax dollars ignores the fact that repaying your loan with pre-tax dollars will overstate the amount of tax-favored payroll deductions made toward your retirement account.
For example, (ignoring interest and earnings for a moment) suppose that your retirement account balance is $50,000 in tax-deferred dollars and you borrow $10,000 (thus the assets in your retirement account receiving tax-favored treatment drop to $40,000) and repayments come from pre-tax payroll deductions. At the point when you complete repaying your loan with pre-tax dollars, you will have restored your tax-favored savings in your account back to $50,000 but you would have had a total of $60,000 in pre-tax payroll deductions (the original $50,000 in your account plus $10,000 in loan repayments.) In this example, you are overstating the amount of tax-favored payroll deductions relative to the amount of tax-favored assets your retirement account, which is not allowed.
The above example was oversimplified to illustrate the point. We cannot, however, ignore interest, earnings, or income taxes. The cost of double taxation on 401(k) loan interest payments is relatively low, certainly when considered against the cost of alternatives such as bank loans. Remember that you pay yourself (or rather your retirement account) the interest from a 401(k) loan, whereas the bank keeps its interest payments.
Suppose you are in a 30% tax bracket and you borrow $10,000 from your 401(k) at an interest rate of 2%. Double taxation of your interest payments will cost you $60 ($10,000 x 2% interest rate x 30% tax bracket.) On the other hand, if you borrow $10,000 from a bank at a rate of 2%, the loan will cost you $200. Naturally, borrowing larger amounts over longer durations amplifies the impact of double taxation of 401(k) loan interest payments.