There are a lot of FRS Special Risk participants who must love paying more than their fair share of taxes. They love paying taxes so much they are willing to pay income taxes twice on the same dollars in their deferred comp plan! The problem is, most of these people have no idea that they are doing this.

So here’s the deal and why you are paying income taxes twice when you take a loan against your deferred compensation.

To begin with, it’s important to understand that, unless your deferred comp plan is a Roth deferred comp, then all the dollars that are in the plan are pre-tax dollars. When you take a loan against the plan, you receive the money tax-free. There is no withholding for taxes, nor does the loan amount become income, forcing you to claim it on your tax return.

All good so far, right?

But when you take that loan, you are required to pay it back over a five-year period with regular payments that are “substantially level.” So how do you make those payments? Either they can come off your work check or you can pay them back from your own account. But here’s the first catch: You pay the loan back with AFTER-TAX dollars.

So if you borrow $10,000 and you are in a 22% tax bracket, you’re going to have to earn roughly $12,820 to have the $10,000 left over after taxes to pay back the loan.

But what about that $10,000 that you have now put back into the plan? Are they—meaning the IRS—considering those pre-tax or after-tax dollars? Well, the thing is, they are considered pre-tax dollars—even though you replaced them with your after-tax dollars!

Now, say you retire immediately after paying that loan off. And say you want to take your deferred comp dollars out and spend them. What happens? All of those dollars are subject to income taxes, even the dollars you put in after-tax to pay off your loan.

That is the second time those same dollars have been taxed. First, when you pay the loan off. And second, when you take them out at retirement.

Now, if you’re in a bind and there’s just no way out other than to take a loan against your deferred comp, being taxed twice on it probably isn’t going to keep you from doing it anyway. But if the loan is not a necessity and you are doing it just because it’s convenient and an easy source of money for whatever the thing is that you want to use it for, then you might want to reconsider.

Unless, of course, you just love paying taxes.

Schedule a complimentary consultation with a fee-only financial planner to discuss your personal situation in more detail.