Whenever personal finance gurus are presented with a question about 401k loans they usually bark back with a list of truisms that should lead you to conclude that a 401k loan is a very bad idea:

• If you lose your job you will have to pay back the loan immediately or face severe tax penalties
• You give up the interest you would have earned had you left that money in the 401k plan for the duration of the loan
• The money you have in your 401k has not been taxed
• When you pay back your loan you are paying with after-tax dollars
• When you withdraw your money on retirement, you pay taxes again

All four statements are true and I won’t argue with any of them, and the last two statements would lead one to conclude that you are in fact faced with double-taxation. Prepare yourself for massive cognitive dissonance: 401k loans are not taxed twice!

To prepare you for the mental gymnastics ahead I have a little warm-up routine for you to follow. It’s a riddle.

Three men go to a hotel and share a room. The total cost for the room is $30, so they each give the hotel manager $10. The hotel manager later discovers that the room was actually only $25 and gives the bellhop the difference of $5 to give back to the men. The bellhop can’t think of an easy way to evenly distribute this money to the three men so he keeps two dollars for himself and gives one dollar back to each man. The men have now each paid $9 for a total of $27 and the bellhop has $2 — what happened to the other dollar?

I hope you are completely befuddled. There is in fact nothing to this riddle except a little misdirection. There is no missing dollar, I just worded the problem in a way that seemed completely logical but in fact has no bearing on the situation whatsoever. You should realize that the three men have $3, the bellhop has $2 and the hotel manager has $25 which sums up to a tidy $30.

The 401k loan problem is similar in that the last three points above are completely true but they do not help you answer the question — are 401k loans taxed twice? I will put forth two scenarios to hopefully bring some clarity to this problem. In both scenarios the man is buying a car for $20,000, he has $20,000 in his 401k and can borrow the entire amount (not true in real life, but simplifies our scenarios), he is retiring in 10 years and he earns 8% on all money he invests.

In the first scenario the man takes out a car loan for $20,000 at 9% for 48 months. He leaves the $20,000 in his 401k to earn 8%. After the loan is paid off he diverts the payments he was making on the car into the 401k for 6 years and then retires.

In the second scenario the man takes out a loan against his 401k at 6% for 48 months. At 6% his payments are less than in the first scenario, so to keep things equal he gets to invest the difference into his 401k. At the end of the 48 months he keeps putting those payments into the 401k for 6 years until he retires.

In both cases he takes out a loan. In both cases he pays back the loan with after-tax money which is the only way you can pay back loan, (I think home equity loans are an exception). The money from the loan is not taxed in both cases. As you can see, the fact that the 401k loan was taken from an account that had pre-tax money in it doesn’t even enter the equation. Again, the last three of the five truisms above that personal finance gurus often hound on aren’t even connected to this problem.

Now, which is better you ask? If you assume that your monthly payments to the 401k loan are then reinvested at 8%, the math that I did showed that the final balance of the 401k loan in the second scenario at retirement had over $10,000 more than in the first scenario. If the payments are not automatically reinvested then I don’t know what the answer is, but it’s probably not as clear cut as you might think. Remember, theoretically you can invest the difference in loan payments so if your 401k loan has a lower rate, you get to invest the difference in pre-tax dollars over the duration of the loan. You have to compare that to what your money would make if it just stayed in your 401k. I’m reluctant to make any guesses without doing the math, (I haven’t had to face this problem yet), but I suspect you’re usually better off just taking a regular loan. My energy for solving theoretical problems has officially run out, so if someone else wants to figure out whether a regular loan is better than a 401k loan assuming your payments are not reinvested immediately I think that would be a great service to everyone. In the mean time, I have the spreadsheet I used and am happy to email it to anyone on request.