More pros and cons of 401(k) loans

A few weeks ago, I passed along advice from a financial expert who recommended against using a 401(k) loan to pay off a mortgage — or for anything else, really.

One reason for that advice from Jeff Salisbury, principal at Independent 401(k) Advisors, with offices in Cache and Davis counties, was that taking out such a loan sets a person up for double taxation. You will most likely repay a 401(k) loan out of your salary, with after-tax dollars, Jeff said. Since you'll have to pay taxes on your 401(k) funds when you withdraw them after you retire, you end up paying taxes twice.

But a reader named Mark sent me an e-mail to say he doesn't necessarily agree.

"If you break down the true financial nature of a 401(k) loan, you'll see that the only piece you pay tax on twice is the interest payment that you make to yourself," Mark wrote. "Everything else is taxed one time."

For example, Mark wrote, if he took out a 401(k) loan for $25,000, that is money on which he has never paid taxes and that he can use to make a purchase or investment tax-free.

"So, instead of using my after-tax dollars to invest in real estate, I'm using my pre-tax 401(k) money ... just a short-term swap, which then gets trued up in the next step," he wrote. "When I repay the $25,000, it is going in as after-tax dollars, thus making Uncle Sam whole again — he didn't get any tax revenue off the $25,000 I am using to buy this real estate, until I pay back the loan with after-tax dollars ....

"However, the interest I pay on the $25,000 is new money going into the 401(k), and it's going in as after-tax dollars. When it is withdrawn during retirement, it will be taxed again. But, this is money that I would have kissed goodbye anyway if I had paid the interest to someone else ... and the rate is so low right now compared to any other rates on unsecured debt. In the end, this is a very small piece of the overall economics of borrowing from yourself."

Mark continues that he thinks the writer of the original question, Eileen, should consider using a 401(k) loan to pay off the mortgage on her vacation home.

"Vacation properties have historically seen above-average appreciation," he wrote. "So, she'll be getting a good return even if the money is out of her retirement account. Plus, she gets to enjoy the use of this summer home while it appreciates. ... What a novel idea to use your tax-free retirement money to help improve your standard of living today, as well as in the future."