Tax and your 401k Loans

It is a common misconception that when you start saving money in a 401k plan, you will be paying income tax twice.

This is in fact sometimes claimed to be one of the reasons why, individuals should not opt for a 401k plan, as the vehicle that will help them save money for their retirement. The claims suggest that when saving in this plan, you will be paying tax first when making loan payments into the plan, and secondly when you come to take the money out, that is when you retire.

This is not true. A loan from your 401k plan, will not incur taxes, more than any other type of loan that you may possibly take from a financial institution. If you do take a loan from your 401k plan, then you will be paying it off from income, which is after-tax. Furthermore, contributions that you make into your 401k plan, as well as all the earnings to gather throughout the years, will only be taxed once; that is when the money is withdrawn, or distributed.

In short this means that withdrawing funds from your 401k plan or from any other source will not cost you more in tax money.

In economics we have a cost which we call the opportunity cost; which is the next best opportunity which you do not choose. In this case the opportunity cost would denote the money or earning that you would have made, if you would have left the saved money in the plan, and taken a loan from another source.

Reference: http://www.401khelpcenter.com/faq/faq_29.html