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US Tax/401k questions


jobyts
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Couple of questions related to US tax/401k related.

 

Q1.

If I have an investment capital loss of say, $10,000 in the current year, I get a tax deduction for a maximum of $3000/year.

 

In the next year, if I have a capital gain of, say $7000, will my taxable capital gain cancel out with the last year's $7000 capital loss?

Or, I need to pay tax for the capital gain of ($7000 - $3000 = $4000)?

 

Q2.

If I take a loan from my 401K, say, I need to pay an interest of 4%. Will this 4% go into my own account that I can invest and later withdraw when I'm elligle to withdraw?

Or, it goes to Fidelity or IRS and I will not see that 4% money again.

 

Thanks in advance.

 

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2 - the interest goes to the plan administrator, not you, not the IRS.

 

get tax advice from a professional, of course

 

The interest goes to the same place as the principle when it is repaid, to your account!

 

nope I am not a professional....... so don't take my word for it

 

 

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I stand corrected - I had always been told the interest went to the plan administrator but have now read otherwise.  What's the point of charging the interest at all I wonder?

 

Well the fact that the interest is doubly taxed is a deterrent for one.  The interest paid comes from taxed salary. Then when you retire and withdraw that interest money it is taxed again.

 

Secondly if there isn't a meaningful interest rate it is like free money, money that has never been taxed free for you to spend.

 

 

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To answer OP:

 

1) The interest you pay goes into your account. You pay yourself interest. At least - that was my understanding when I looked into doing this myself (but never did).

 

2) The whole $7,000 would be offset assuming that the gain/loss are both long-term or short-term in nature. The limit of $3,000 was for capital losses to offset income - not for offsetting other capital gains. If you 100k in capital gains, you can offset that with 100k in capital losses in the same year. There's no limit for offsetting gains/losses of the same time - just limiting how much of a deduction you can take against your income for the year.

 

 

I stand corrected - I had always been told the interest went to the plan administrator but have now read otherwise.  What's the point of charging the interest at all I wonder?

 

Well the fact that the interest is doubly taxed is a deterrent for one.  The interest paid comes from taxed salary. Then when you retire and withdraw that interest money it is taxed again.

 

Secondly if there isn't a meaningful interest rate it is like free money, money that has never been taxed free for you to spend.

 

I'm generally tired of hearing this "you pay it back with after-tax dollars". It seems totally irrelevant to 99% of people taking loans against 401k. Taking a loan against a 401k is a cheap form of financing - it comes with a low rate and you're paying yourself. How is ALL financing paid back? With after-tax dollars. It's irrelevant if the 401k is also paid back in after tax dollars. All that's relevant is the rate and the terms - the terms of 401k loans can be onerouse, but a 0% rate (cuz you're paying yourself) is hard to beat. 

 

The only time the tax function comes into play is if you're looking to borrow against your 401k to leverage returns in other investments (as opposed to needing the money or using as a form of financing for an investment you'd make regardless). Then you'd have to compare the forward looking rate of return within the 401k to solve for the value of the tax-deferred compounding on the amount you intend to borrow. That is your cost. PV that cost and compare it to the cost of interest on the loan you would have to take from a private institution. I don't think the tax-deferred benefit of the compounding comes out to be anywhere near 6-10% per year on your principle which is what it would likely have to come to for other forms of financing to make sense. Further, this analysis is highly, highly dependent on assumptions used for future growth of the 401k and the rate you discount it back to find PV - a largely useless exercise.

 

 

 

 

 

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http://www.investopedia.com/articles/retirement/08/borrow-from-401k-loan.asp

 

I recently took a 401k loan to finance a new car. My first option would have been to pay cash. but I am fully invested in stocks and I would have to sell stocks (and pay capital gain tax) if I pay cash. I also didn't want to take a car loan because I am buying a house and that would hurt my credit score. I also need the cash for down payment. So I thought this is a good time to use 401k loan. After all, you pay interest to yourself and the only thing you lost is the potential tax free investment gain and the double taxation on the interest, and the market could fall too. In addition I plan to pay back the loan within a year so I don't lost too much.

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I stand corrected - I had always been told the interest went to the plan administrator but have now read otherwise.  What's the point of charging the interest at all I wonder?

 

Well the fact that the interest is doubly taxed is a deterrent for one.  The interest paid comes from taxed salary. Then when you retire and withdraw that interest money it is taxed again.

 

Secondly if there isn't a meaningful interest rate it is like free money, money that has never been taxed free for you to spend.

 

 

 

When you say double taxed -  do you mean since you can't deduct the interest rate that you pay to your 401k, as interest expense, as opposed to mortgage interest? Also, whatever you earn on the 401k, you'll have to pay taxes on when you take distributions, no? So what's the difference if you earn that from charging interest to yourself or you earn it from investment gains? It's not really a tax loss if you owe taxes no matter what.

 

Which makes me wonder, can you borrow against a Roth 401k, or a Roth IRA? What is stopping someone from borrowing from themselves at like a 20% interest rate from a Roth, which can be used as an indirect way to contribute even more money to a retirement account? Or even if it's not a Roth, but a Traditional, what's stopping someone from overcharging interest to themselves in order to contribute more? Or are there laws preventing this?

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Read in the review section of (http://www.savingtoinvest.com/maximum-employee-and-employer-401k-contribution-limits-and-catch-up-amounts/) that loan repayment is not counted towards the yearly contribution limit. So, by taking a loan and repaying it with interest, one can technically contribute more than the yearly allowed limit, and hence grow more money without paying taxes after each stock sell.

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I stand corrected - I had always been told the interest went to the plan administrator but have now read otherwise.  What's the point of charging the interest at all I wonder?

 

Well the fact that the interest is doubly taxed is a deterrent for one.  The interest paid comes from taxed salary. Then when you retire and withdraw that interest money it is taxed again.

 

Secondly if there isn't a meaningful interest rate it is like free money, money that has never been taxed free for you to spend.

 

 

 

When you say double taxed -  do you mean since you can't deduct the interest rate that you pay to your 401k, as interest expense, as opposed to mortgage interest? Also, whatever you earn on the 401k, you'll have to pay taxes on when you take distributions, no? So what's the difference if you earn that from charging interest to yourself or you earn it from investment gains? It's not really a tax loss if you owe taxes no matter what.

 

 

What he means is that the money you put into your 401(k) is tax deferred. You don't pay taxes on those deposits and their earnings until you withdraw money in retirement. So only one set of taxes - those paid when you withdraw.

 

If you take a 401(k) loan and spend that money, you're paying back pre-tax contributions that you borrowed with post-tax dollars from your paycheck (tax #1). Then once it's paid back, you'll pay taxes on it again when you withdraw in retirement (tax #2).

 

People say it's a bad idea to borrow from your 401(k) because of that double-taxation, but the point that I made above is that ALL forms of borrowing are paid post tax, so if you're going to have to borrow, that shouldn't be what keeps you from doing a lower interest option.

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Read in the review section of (http://www.savingtoinvest.com/maximum-employee-and-employer-401k-contribution-limits-and-catch-up-amounts/) that loan repayment is not counted towards the yearly contribution limit. So, by taking a loan and repaying it with interest, one can technically contribute more than the yearly allowed limit, and hence grow more money without paying taxes after each stock sell.

 

This is an interesting angle.  I don't know a lot about these things, cause I never considered them, but I think this would only be smart if the interest was higher than the expected return in your plan.

 

For example, I know someone who was thinking about taking a 401k loan and the interest was 4%.  You pull out 100k, but in 1 year the lost gains on the amount pulled out are likely to be greater than 4k.  Plus you lose whatever that 4k would have done in your taxable account.

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Read in the review section of (http://www.savingtoinvest.com/maximum-employee-and-employer-401k-contribution-limits-and-catch-up-amounts/) that loan repayment is not counted towards the yearly contribution limit. So, by taking a loan and repaying it with interest, one can technically contribute more than the yearly allowed limit, and hence grow more money without paying taxes after each stock sell.

 

That point may be correct but there are other ways to top up the 401k.  In my company 401k there is nothing stopping you from contributing double the yearly IRS contribution limit. The IRS contribution limit is the max amount of tax deferred contribution you may make.  The rest is post tax money.

 

 

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People say it's a bad idea to borrow from your 401(k) because of that double-taxation, but the point that I made above is that ALL forms of borrowing are paid post tax, so if you're going to have to borrow, that shouldn't be what keeps you from doing a lower interest option.

 

Sure, I agree with your point. But I am saying there are deterrents to borrowing from your 401k to make frivolous loans.

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People say it's a bad idea to borrow from your 401(k) because of that double-taxation, but the point that I made above is that ALL forms of borrowing are paid post tax, so if you're going to have to borrow, that shouldn't be what keeps you from doing a lower interest option.

 

Sure, I agree with your point. But I am saying there are deterrents to borrowing from your 401k to make frivolous loans.

 

Well, my only response would be that it's always a bad idea to take frivolous loans and that has nothing to do with the double-taxation of the repayment ;)

 

We can let this go though, lol

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I stand corrected - I had always been told the interest went to the plan administrator but have now read otherwise.  What's the point of charging the interest at all I wonder?

 

Well the fact that the interest is doubly taxed is a deterrent for one.  The interest paid comes from taxed salary. Then when you retire and withdraw that interest money it is taxed again.

 

Secondly if there isn't a meaningful interest rate it is like free money, money that has never been taxed free for you to spend.

 

 

 

When you say double taxed -  do you mean since you can't deduct the interest rate that you pay to your 401k, as interest expense, as opposed to mortgage interest? Also, whatever you earn on the 401k, you'll have to pay taxes on when you take distributions, no? So what's the difference if you earn that from charging interest to yourself or you earn it from investment gains? It's not really a tax loss if you owe taxes no matter what.

 

 

What he means is that the money you put into your 401(k) is tax deferred. You don't pay taxes on those deposits and their earnings until you withdraw money in retirement. So only one set of taxes - those paid when you withdraw.

 

If you take a 401(k) loan and spend that money, you're paying back pre-tax contributions that you borrowed with post-tax dollars from your paycheck (tax #1). Then once it's paid back, you'll pay taxes on it again when you withdraw in retirement (tax #2).

 

People say it's a bad idea to borrow from your 401(k) because of that double-taxation, but the point that I made above is that ALL forms of borrowing are paid post tax, so if you're going to have to borrow, that shouldn't be what keeps you from doing a lower interest option.

 

Hmm ok.

 

Say you take out a $100k loan, and pay back with interest $110k. When you retire and take distributions, you have to pay tax on the $100k which I agree is not really double taxation. But do you have to pay tax on the $10k interest as well? If so, then wouldn't that portion would be double taxation?

 

I know when you take distributions from an IRA account, you don't have to pay state taxes on the amount you deposited post tax, at least in NJ which doesn't allow IRA deductions. So if you contribute $6,000 to an IRA, and that grows to $10,000. While you would owe Federal tax on the full $10k, you only owe it on $4k in NJ.

 

Edit: On second thought the $10k isn't really double taxation because the lender/investor (401k) made a profit, just as you would from dividends on stocks. Therefore of course it would make sense to owe taxes on it. It just sucks if you're the borrower as well, but it makes sense.

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What he means is that the money you put into your 401(k) is tax deferred. You don't pay taxes on those deposits and their earnings until you withdraw money in retirement. So only one set of taxes - those paid when you withdraw.

 

If you take a 401(k) loan and spend that money, you're paying back pre-tax contributions that you borrowed with post-tax dollars from your paycheck (tax #1). Then once it's paid back, you'll pay taxes on it again when you withdraw in retirement (tax #2).

 

People say it's a bad idea to borrow from your 401(k) because of that double-taxation, but the point that I made above is that ALL forms of borrowing are paid post tax, so if you're going to have to borrow, that shouldn't be what keeps you from doing a lower interest option.

 

Hmm ok.

 

Say you take out a $100k loan, and pay back with interest $110k. When you retire and take distributions, you have to pay tax on the $100k which I agree is not really double taxation. But do you have to pay tax on the $10k interest as well? If so, then wouldn't that portion would be double taxation?

 

I know when you take distributions from an IRA account, you don't have to pay state taxes on the amount you deposited post tax, at least in NJ which doesn't allow IRA deductions. So if you contribute $6,000 to an IRA, and that grows to $10,000. While you would owe Federal tax on the full $10k, you only owe it on $4k in NJ.

 

Edit: On second thought the $10k isn't really double taxation because the lender/investor (401k) made a profit, just as you would from dividends on stocks. Therefore of course it would make sense to owe taxes on it. It just sucks if you're the borrower as well, but it makes sense.

 

When I first mentioned double taxation I am talking about double taxation on the gains. Not the original principle (aka contributions).  So suppose you want a $100k loan and pay 4% interest.  You have to earn $6k to keep $4k post tax to pay that interest per year. That $4k is in your 401k but when you withdraw  you keep $3k after tax. So earned $7k but kept only $3k because of double taxation. I am not sure what TwinCities meant.

 

Other examples or double taxation is when you pay tax withholding on foreign stocks in your ira. That tax paid is not recognized when you withdraw at retirement.

 

As for the IRA taxation that isn't right. I hope you filled out a form 8606 for you non deductable contributions. Non deductable contributions is post tax money.  That amount is basis and is deducted from your account to derive your gains which is taxed when you withdraw.  Form 8606 is a federal form so it means it apples to federal taxation. no? if not I am really wrong on my tax planning.

 

 

 

 

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Twocities is right.  He's right and you're smart, so eventually you will agree with him.  ;D

 

The more sophisticated analysis, should compare the cost of repaying a loan to a third party to that of the foregone capital gains/income (losses?) (character isn't relevant because the ordinary rate applies regardless) on the principal that is withdrawn from the tax deferred account in the form of a "loan".  Of course you don't know what the forward returns will be ex-ante, but the "double tax" of the earnings in the tax advantaged account (whether generated by interest paid to oneself to maintain the fiction of a loan to avoid an immediately taxable distribution, or the gains on the principal in the account not so withdrawn and invested) is not the critical factor, but it is an easy rule of thumb to discourage generally undisciplined people from taking withdrawals (if I pay CS 5% of $1,000 or pay myself 5% of 1000, which will eventually be taxed at 25%...but what if the $1000 would have earned X% (or -X) in my VTI...)

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What he means is that the money you put into your 401(k) is tax deferred. You don't pay taxes on those deposits and their earnings until you withdraw money in retirement. So only one set of taxes - those paid when you withdraw.

 

If you take a 401(k) loan and spend that money, you're paying back pre-tax contributions that you borrowed with post-tax dollars from your paycheck (tax #1). Then once it's paid back, you'll pay taxes on it again when you withdraw in retirement (tax #2).

 

People say it's a bad idea to borrow from your 401(k) because of that double-taxation, but the point that I made above is that ALL forms of borrowing are paid post tax, so if you're going to have to borrow, that shouldn't be what keeps you from doing a lower interest option.

 

Hmm ok.

 

Say you take out a $100k loan, and pay back with interest $110k. When you retire and take distributions, you have to pay tax on the $100k which I agree is not really double taxation. But do you have to pay tax on the $10k interest as well? If so, then wouldn't that portion would be double taxation?

 

I know when you take distributions from an IRA account, you don't have to pay state taxes on the amount you deposited post tax, at least in NJ which doesn't allow IRA deductions. So if you contribute $6,000 to an IRA, and that grows to $10,000. While you would owe Federal tax on the full $10k, you only owe it on $4k in NJ.

 

Edit: On second thought the $10k isn't really double taxation because the lender/investor (401k) made a profit, just as you would from dividends on stocks. Therefore of course it would make sense to owe taxes on it. It just sucks if you're the borrower as well, but it makes sense.

 

When I first mentioned double taxation I am talking about double taxation on the gains. Not the original principle (aka contributions).  So suppose you want a $100k loan and pay 4% interest.  You have to earn $6k to keep $4k post tax to pay that interest per year. That $4k is in your 401k but when you withdraw  you keep $3k after tax. So earned $7k but kept only $3k because of double taxation. I am not sure what TwinCities meant.

 

Other examples or double taxation is when you pay tax withholding on foreign stocks in your ira. That tax paid is not recognized when you withdraw at retirement.

 

As for the IRA taxation that isn't right. I hope you filled out a form 8606 for you non deductable contributions. Non deductable contributions is post tax money.  That amount is basis and is deducted from your account to derive your gains which is taxed when you withdraw.  Form 8606 is a federal form so it means it apples to federal taxation. no? if not I am really wrong on my tax planning.

 

Now run through the same example at a slightly higher rate for an unsecured loan (7-8%?) and see which one you're better off with. Nobody is saying you're not double-taxed, but avoiding double-taxation isn't the point of taking a loan. The point of taking a loan is financing a need at the lowest cost available and unless if you're taking some form of secured debt (like a mortgage), the 401(k) loan is probably going to have the lowest total cost of anything else available even considering the double taxation.

 

This is why I hate it when people bring up the point. It's an immediate dismissal of a form of financing without doing any comparative analysis to other forms of financing.

 

 

 

 

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Now run through the same example at a slightly higher rate for an unsecured loan (7-8%?) and see which one you're better off with. Nobody is saying you're not double-taxed, but avoiding double-taxation isn't the point of taking a loan. The point of taking a loan is financing a need at the lowest cost available and unless if you're taking some form of secured debt (like a mortgage), the 401(k) loan is probably going to have the lowest total cost of anything else available even considering the double taxation.

 

This is why I hate it when people bring up the point. It's an immediate dismissal of a form of financing without doing any comparative analysis to other forms of financing.

 

TwoCities, I thought in my first reply you understood I agreed with your point. Why are you beating me over the head with it a second time? LOL

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Now run through the same example at a slightly higher rate for an unsecured loan (7-8%?) and see which one you're better off with. Nobody is saying you're not double-taxed, but avoiding double-taxation isn't the point of taking a loan. The point of taking a loan is financing a need at the lowest cost available and unless if you're taking some form of secured debt (like a mortgage), the 401(k) loan is probably going to have the lowest total cost of anything else available even considering the double taxation.

 

This is why I hate it when people bring up the point. It's an immediate dismissal of a form of financing without doing any comparative analysis to other forms of financing.

 

TwoCities, I thought in my first reply you understood I agreed with your point. Why are you beating me over the head with it a second time? LOL

 

Sorry - was quoting that more for Mephistopheles and less for you. Not trying to beat you over the head with it - just demonstrating that even once you have a full understanding of the double taxation, that it doesn't really matter.

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