Tax #1 does not exist because the money you are getting out = the money you are putting back in. If your proceeds of the loan were taxed, then yes, but they are not. It does not matter that you are paying it back with "after tax" dollars because you are paying back exactly the proceeds of the loan. There is no magical tax there...I don't know why people think this.
I am not advocating that this is how you should finance a down payment on a house at all, I am just correcting the misinformation that the money is double taxed...it is not...Also, it depends on your plan whether or not you have to pay it back in full if you lose/quit your job...not all plans make you do that - the terms of the loan and whether or not you have to pay it back are plan specific.
IT is not a separate tax - it is the fact you pay back the loan from the 401K with dollars you earn that are taxed.
Ex: Withdraw 10K from the 401K in loan form
Pay back 10K
However to get the 10K to pay the money back- you need to earn MORE than 10K AND pay taxes on it. So yes, it does matter that you pay back401K loan money that was initially put in tax free with after tax dollars.
Then there is the fact that you do not "make money" while the money is out of the 401K.
Just looking at it from a principal loan taxation point - you are looking at it as if you are having to make that money to pay back the loan, whereas, what you are really doing, is making that post-tax money to pay whatever it was that you needed the loan for (the loan is an advance for something for which you will then get the money to pay for over time). Net net, the tax situation is no different than you borrowing money from your bank to pay for whatever it is you need the loan for.
For example: You take a $10K loan from your 401K, you have a savings account with $10K in it. The next day, you take your money from your savings account, and pay off the loan. Did you pay taxes by taking out and repaying that loan? No, because the $10K from your 401K loan was pre-tax and was not taxed when taken out. You paid it back with post tax dollars, but the new $10K you have from the loan is pre-tax dollars. You are creating a double tax in a situation where it is tax neutral. The only double tax that truly does exist is on the interest you pay, which is minimal.
Sisugal - you are very smart and I enjoy reading your posts here and in MM, but I just can't agree with you on this one. It is mathematically incorrect.