There's still more debate on 401(k) loans

Last week, I shared reader responses to recent columns that recommended against taking out a 401(k) loan, focusing on an assertion that money used to pay back such a loan would, in effect, be taxed twice.

But those weren't the only responses I received to what is, apparently, a hot-button issue for some, so this week I'm going to include a couple more.

A reader named Tom wrote that, even though there is double-taxation of the interest you pay into your 401(k) for a loan you have taken out, that interest will grow on a tax-deferred basis.

"Let's say you put $10 in an account for 20 years that's earning a real interest rate (net of inflation) of just 3 percent," Tom wrote in an e-mail. "After 20 years, that $10 has grown to $18.06. So even after you take out, say, 35 percent for taxes, you still net $11.73, which is more than the $10 you put in (again, you've already accounted for inflation in the net interest rate). So the tax-deferral benefit actually more than offsets the 'double taxation' issue."

Tom attached spreadsheets to further prove his point, but I am not able to reproduce them here. (Also, I'm a journalist, and therefore naturally math-averse.)

Tom went on to comment on the original question in my earlier columns, which focused on the wisdom of using a 401(k) loan to pay off the mortgage on a vacation home.

"For the purposes of answering that question, the rate of appreciation of vacation properties is irrelevant — she owns that property regardless of what she decides to do about the mortgage," Tom wrote. "The relevant rate of return for Eileen's question is the interest rate on the mortgage loan (net of any tax benefits she receives from her mortgage interest deduction) vs. what she could earn in her 401(k). So if Eileen's interest rate is 6 percent on her mortgage and she can write off all the interest at a 33 percent tax rate, her net cost on the mortgage is only 4 percent. As long as she can earn more than 4 percent on her 401(k) money (should be easy to do that), she should keep the money in her 401(k).

"Now, if the decision facing Eileen were whether to BUY a vacation property (that she doesn't already own) using 401(k) money, then the rate of appreciation in the vacation property would be relevant."

Tom, you make some good points here. I appreciate your writing in.