Revisiting the 401(k) loan debate

It's been several weeks since we talked about 401(k) loans. I'm refreshed, and I'm ready. Let's wade back in.

As you may recall, those past columns passed along advice from a financial expert who said people should avoid taking out 401(k) loans to pay off the mortgage on a vacation property or for other reasons.

He argued that taking out such a loan sets a person up for double taxation, because you will most likely repay it out of your salary, with after-tax dollars. Then you'll have to pay taxes on your 401(k) funds when you withdraw them after you retire. Also, that 401(k) money is supposed to be for the future, and people should not use their retirement accounts to buy things they want today.

These comments drew many reader responses. I'm going to share some of them this week and next, so you can make up your own mind on this issue.

A reader named David sent me an e-mail to say he does not think a 401(k) loan represents double taxation. He wrote that such loans can be a good source for funds "in the event of an unexpected need where the alternative is taking a hardship distribution from the 401(k) account or if there just is not another source of funds. ... I would tend to agree with the overall conclusion about 401(k) loans, but not about the double tax."

A reader named Linda also commented on the double-taxation argument.

"I understand his point that he is using pre-tax money for investments outside the 401(k) if he pursues the loan, but when he pays that money back it is no longer pre-tax," she wrote in an e-mail. "If he is paying the entire payment (principal and interest) using after-tax money, the entire loan balance plus interest will now be part of his 401(k) balance as after-tax money. Obviously, when he begins distributions from the 401(k) at retirement age, there is no after-tax status for money being distributed so once again he will be taxed on the entire balance.

"Just a wild guess on my part, but it sure looks to me like he is paying tax twice on both principal and interest. For the record and my experience with 401(k) participants, I hope the majority agree with (the expert) opinion and keep their sacred retirement money just that. If they are investor savvy enough to be weighing the pre-tax and after-tax options, then perhaps they should hire an investment adviser to manage the rest of their portfolio and leave their hard-earned 401(k) dollars to (their) intended purposes."

Bob, a pension attorney from Michigan, sent an e-mail to say he disagreed with the advice from my original columns.