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This Old House

Greg Spears

WHEN WE MOVED to Pennsylvania in 1996, I wanted to buy an old house. After months of looking, we found a stone farmhouse close to my new job and in a good school district. There was just one problem: We didn’t know if we could afford it.

We hadn’t been able to sell our home in Maryland, so we didn’t have any home equity to bring to the table. When our real estate agent saw the asking price, she declined to show us the place because it was out of our price range. She wasn’t wrong.

We drove over to look anyway. It was a stone house with big mature trees. A light snowfall made the property look like a Currier & Ives print. Our kids ran around the yard, jumping in the creek out front. We had to drive home to get our seven-year-old son into dry clothes. But in just a few minutes, we’d fallen for the place.

From the visit, I got an idea for how we might afford the property. It had a small cottage, separate from the main house, which might provide rental income that we could then use to help cover the mortgage. We still needed a large down payment, however. But I also had an idea for where to get that money. I’d borrow from myself.

First, I rolled an IRA into my new 401(k) plan at work. Once it was transferred, I borrowed the maximum allowed from the plan—$50,000. I’d have five years to repay the loan through automatic payroll deductions. The interest rate was the prime rate plus 1%, as I recall.

Plan loans are the most popular 401(k) feature—after the employer match, that is. At any given time, one worker in eight has a 401(k) loan outstanding. Because you’re borrowing from your own savings, you don’t need a bank’s approval. It’s also easy to apply. Often, you just fill out an online form or talk with a phone representative.

There was still one hitch, however. Borrowing from the 401(k) went against the advice of my new employer, Vanguard Group. It wasn’t a strict prohibition. Vanguard does allow loans from its 401(k) plan. But the company’s stated position was that money saved for retirement should be used only for retirement.

This argument has real merit. It’s hard enough for many Americans to amass enough for retirement. We tend to start saving later in our careers. Many workers also don’t set aside enough each month. Why take money out of an account that may already be too small?

I knew that I was a good saver, contributing as much as I could to the plan. At the rate I was going, I didn’t think there would be a shortfall at retirement. I didn’t want to miss out on other goals. Buying a nice house in a good school district would make my work feel more rewarding.

Vanguard had other, more specific reasons to counsel workers against borrowing. The money would be “out of the market” until it was paid back. This meant I would miss out on gains if there was a runup in stock prices. But by the same token, I might avoid a loss if share prices happened to drop while I had a loan outstanding. This was a bit of a toss-up because it depended on timing.

Vanguard’s strongest argument was that some borrowers can’t repay their loans, usually because they lose their job. This can set off a financial avalanche. Any remaining balance comes due in full, usually within 60 to 90 days, depending on plan rules. If the borrower can’t make the balloon payment, the unpaid balance is subtracted from the borrower’s retirement savings. This is reported to the IRS as a taxable distribution, subject to income taxes and usually a 10% early withdrawal penalty.

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Under this worst-case scenario, you could lose your job, default on the loan, lose a chunk of your savings and then owe the IRS money. Approximately $6 billion in 401(k) savings are lost this way each year, according to a 2015 estimate by researchers from Peking University, University of Pennsylvania’s Wharton School and Vanguard. Their estimate was higher than that found in previous studies.

I could imagine a black swan event like this occurring, just not to me. Like most people, I had faith in “recency”—that the current conditions I enjoyed would flow seamlessly into the future. I felt confident that my job was safe and my health would remain good.

That doesn’t always happen, of course, but everything worked out fine for us. As I look back, I realize that I’d taken a big gamble that luckily turned out okay. Yet I’d probably do the same thing all over again in the same circumstances. Like the idea of borrowing from your 401(k)? Here are four suggestions to make such loans less risky:

Borrow infrequently. I took just one loan from my 401(k) during my career. If you borrow, do it for something vitally important, and not for a luxury purchase or a vacation.

One at a time. Some 401(k) plans allow workers to have more than one loan outstanding at any given time. Those who take out two loans or more have a higher rate of defaulting. They’re often borrowing from Peter to pay Paul.

Not an emergency fund. Workers who borrow from the 401(k) to pay the rent or make a car payment could benefit from credit counseling. People who treat their 401(k) like an emergency fund are living too close to the edge.

Make sure your job is secure. Before borrowing, think carefully about your employer’s financial condition and your relationship with your boss. The most important thing by far is to not lose your job while you have a loan outstanding. If you can avoid that, things tend to work out okay. More than 90% of plan loans are repaid on time.

Greg Spears is HumbleDollar’s deputy editor. Earlier in his career, he worked as a reporter for the Knight Ridder Washington Bureau and Kiplinger’s Personal Finance magazine. After leaving journalism, Greg spent 23 years as a senior editor at Vanguard Group on the 401(k) side, where he implored people to save more for retirement. He currently teaches behavioral economics at St. Joseph’s University in Philadelphia as an adjunct professor. The subject helps shed light on why so many Americans save less than they might. Greg is also a Certified Financial Planner certificate holder. Check out his earlier articles.

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MarkT29
MarkT29
4 months ago

Before taking a loan people should understand what happens if they leave their job before the loan is repaid. In many cases you are required to repay the loan within a short period or it is considered a taxable distribution. In a sense you are handcuffed to your employer.

In early 1997 I faced a similar situation to this article. I thought about buying a house we saw for sale but almost all my savings were in my 401K plan. I decided against a loan due to the repayment/tax rules.

Was it the right decision? I still wonder. My employer ran into strong headwinds and had layoffs within a year. Most other people, myself included, left on our own and the shell of the company was sold. So I did dodge an unexpected tax bill and a big drop in my 401K balance. On the other hand I had no way of knowing CA real-estate was about to skyrocket. The area we wanted quickly sailed out of reach. We live about 10 miles away in a nice community, but housing prices are literally half what they are in the other town.

hamik m
hamik m
4 months ago

It’s unfortunate that the 401K loan limit is still at $50K, same as it was at least since 1996. The 1996 loan would be about $94K in 2022 dollars. It seems like limits intended to help the individual investor are not adjusted for inflation. The ability to deduct $3k capital losses on income is another example. It hasn’t changed for decades as far as I know. The AMT limits (pre-Trump tax law change) is another example.

However, the payroll taxes are adjusted reliably every year.
If the investor pays, it’s adjusted reliably. If its something the investor might gain from, its ignored.

BenefitJack
BenefitJack
4 months ago

Great story, and, I can confirm based on my 31+ years in plan sponsor roles, that is typical of tens of thousands of other American households: ~90% of plan loans are successfully repaid. At the same time, ~90% of plan loans outstanding at separation default and trigger leakage.

However, my experience is that most leakage results from failures by the plan sponsor/plan administrator. Specifically, Vanguard failed you when they said you needed to repay the loan in full upon separation:

  • Failed to adopt electronic banking to take payments from a bank account should loan payments stop from payroll (childbirth, separation, etc.), and
  • Failed to counsel/educate the participant to have a ready source of liquidity – in your situation, it would have been a line of credit on the new home (or the Maryland home, if you prefer).

Regarding Vanguard’s other concerns about borrowing, they are all misplaced/wrong:

  • “Money out of the market” – The plan loan principal is a fixed income investment (for you, it was prime +1%). If you borrowed $50,000, that means that your account exceeded $100,000. So, after taking the loan, you need to rebalance your account so your equity exposure is unchanged from pre-loan levels (where the plan loan principal becomes a portion of your fixed income investment).
  • Return on Investment – The plan loan interest rate, assuming you were paying it back to your own account (versus the TIAA methodology) is likely better than the rate of return you would typically get on intermediate term bonds (certainly true over the last 15+ years), AND less than the rate you would pay for most commercial loans. So, the plan loan likely improved both your household wealth AND your retirement preparation!
  • Hopefully, once the Maryland home was sold, the Vanguard plan allowed you to accelerate and repay the plan loan – if that was the best use of the home equity from the sale of the Maryland home.
  • “Borrow Infrequently” – Never borrow from the plan unless you need liquidity AND it is the best option – frequency should never play a role. One federal reserve study, nearly 15 years ago, confirmed Americans could improve their household wealth by borrowing MORE from their plans. See: https://www.federalreserve.gov/pubs/feds/2008/200842/200842pap.pdf
  • “One at a time” – Why limit the participant to one loan if the second plan loan would be a better option than a loan from a commercial source? For example, say that the commercial loan has an interest rate of 10% and the plan loan has an interest rate of 6%. Wouldn’t an embrace of “financial wellness” by the employer prompt them to allow the worker to borrow where the payments are less, repayment is more likely, and where the loan would likely increase both retirement preparation and household wealth?
  • Living too close to the edge – Actually, a 401k with liquidity features, done right, is a wonderful advantage to those living paycheck to paycheck. Most who live paycheck to paycheck don’t believe they can afford to save, or don’t believe they can afford to earmark monies for a distant, uncertain, future, perhaps unlikely retirement. So, “liquidity without leakage” is often necessary (and certainly better than in-service withdrawals) as a means of facilitating savings – so that the individuals can leverage both the tax preferences and the employer matching contribution.
  • Job security – Actually, no. The median tenure of American workers has been less than 5 years for the past 5 decades. Assume the job is always insecure and prepare accordingly. And, if a plan loan default is a possibility, consider using Roth 401k (instead of pre-tax 401k) to minimize any penalty taxes.

For more myths about plan loans, see: https://401kspecialistmag.com/top-10-401k-plan-loan-myths-misdirections-and-misrepresentations/

SanLouisKid
SanLouisKid
4 months ago

Years ago, I worked for a company that had only a profit share plan. In good years up to 15% of your salary deposited in your account. You could not contribute your own money. One day I asked where “Harry” was and they said he quit. The only way to access your profit share account was to retire at 65 or quit. You couldn’t “borrow.” Harry wanted his profit share money to buy a fishing boat. I always wondered how his retirement worked out.

Nate Allen
Nate Allen
4 months ago
Reply to  SanLouisKid

Wow, that is commitment. He must have really wanted that boat..

parkslope
parkslope
4 months ago

A key item that is missing from your story is the fate of your Maryland home. Did you sell it as soon as possible after you moved or did you rent it? Did the net proceeds allow you to pay off your loan or a significant portion of it?

Greg Spears
Greg Spears
4 months ago
Reply to  parkslope

Yes, we did use money from the rental to pay about one-half the monthly mortgage amount. Now the mortgage is paid off, and the rental is providing us with income.

Luckless Pedestrian
Luckless Pedestrian
4 months ago
Reply to  Greg Spears

Is the “rental” you refer to here the cottage on the Pennsylvania property, or is it the house you own(ed) in Maryland? I believe Parkslope was asking about the latter.

Greg Spears
Greg Spears
4 months ago

Thanks for pointing that out. We rented our Maryland house for a couple of years, as I recall. We were waiting for housing prices to rise so we could get what we paid. When we finally sold, we did take a small loss.

steveark
steveark
4 months ago

I’m glad it worked out so well for you. I do think for most people that’s too big of a risk to take, stretching for a house to the extent you have to borrow from retirement. We chose a very modest house which we are still in 43 years later, which is much less modest now, due to doubling its size and keeping it modern via many retrofits and expansions over the years, done with cash. We were able to pay it off decades ago and it’s nice not having a mortgage, especially in retirement.

Greg Spears
Greg Spears
4 months ago
Reply to  steveark

There used to be a pseudo rule to stretch to buy the best house you could afford. We followed it and we’re lucky, frankly. I think that would be a mistake today, given the rapid rise in house prices and rising mortgage rates. I congratulate you on your success.

R Quinn
R Quinn
4 months ago

When I set up two 401k plans I resisted putting in loans, but the consultants talked me out of it. Workers need access to their money, they said.

I fell victim to a small loan once myself during our college paying years. I wish I hadn’t.

A women who worked for me was constantly borrowing to pay off her credit cards. I tried counseling her and once she said the next loan would be her last, but the credit card balances grew again. She panicked once when her husband asked why her 401k wasn’t growing.

She was the victim of another risk taking loans; BOTH the loan payments and contributing to the plan are unaffordable sometimes to the extent of missing the employer match.

Many people don’t realize they are not paying interest to themselves, but to the plan trust so when they make a withdrawal they are paying income tax on the interest they paid on their loan(s).

Randy Starks
Randy Starks
4 months ago
Reply to  R Quinn

Hum, I researched where the interest payments go for a typical 401k loan and this is what I found (below) and it was the case with my 401k loans. It went back into my 401k account not to the plan administrator (Vanguard).

“Although your 401(k) administrator is facilitating your 401(k) loan and not a bank, there is a method in deciding what interest rate you’ll pay on your loan. While the interest you pay on your 401(k) goes back into your 401(k) account, your plan’s administrator will set your rate for you.”

Last edited 4 months ago by Randy Starks
BenefitJack
BenefitJack
4 months ago
Reply to  Randy Starks

As Dick Quinn confirms, in most plans, the interest you pay on a plan loan is credited to your account – and typically allocated on the same basis as the principal repayment (in terms of investment allocations, often allocated on the same basis as your ongoing contributions). However, there is another process used in some plans – where, upon taking a loan, the principal is transferred to a specific investment (typically a money market or other fixed income investment), and the interest you pay becomes part of the investment return for that investment option.

R Quinn
R Quinn
4 months ago
Reply to  Randy Starks

Every asset you have in a 401k is in the plan trust legally and allocated to your account. Yes, the interest shows up in your account as does the employer match even if not yet vested.

There are IRS guidelines for setting the interest rate, usually done by or in conjunction with the plan sponsor- the employer. Hopefully the idea is to keep it as low as possible.

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