Your 401(k): Nest egg or slush fund?

One of our readers recently asked about Vanguard’s view on 401(k) loans.

As you might know if you’ve poked around Vanguard.com, we generally frown upon retirement plan loans, to put it mildly. In fact, Vanguard’s intranet for employees recently featured an article cautioning us against borrowing from our own retirement accounts.

Titled “He [or she] that goes a borrowing goes a sorrowing,” the article noted that Benjamin Franklin’s favored method for making difficult decisions was to put together “a side-by-side list of the reasons for and the reasons against a certain course of action.” To help out, the article offered a list of “negative consequences of taking a loan.” It may have been a bit over the top, but I basically agree that retirement plan loans can be misused. There is always a cost to borrowing, and with plan loans there are some risks. 

You shouldn’t borrow from your retirement plan—or from anywhere else, in general—unless you really have to, in order to pay for something that is a necessity. In this category I’d include a house, a higher education, and perhaps a (first) automobile. I’d also include large unexpected medical bills, or the money required to deal with a true family emergency. But I think you have to think twice about borrowing anywhere (banks, credit cards, or your retirement savings) to fund things that you don’t absolutely need. In my view, an overeagerness to borrow on the part of consumers was a major driver in the financial crisis we’re now going through.

But now to the neglected potential benefits of a 401(k) loan.

If you’re in a position in which you need a loan for a real necessity, then it’s totally appropriate to consider borrowing from your 401(k). The essential advantage of a plan loan is that instead of paying interest to a third party, you pay it to yourself, so the cost of the loan is whatever administrative fees you pay plus any lost return on the assets that you’ve borrowed. In most circumstances—particularly if you don’t have stellar credit—this means 401(k) loans have lower total costs than the alternatives.

(Another cost: The interest you owe on your plan loan is paid back to your account with after-tax dollars, and when you withdraw it in retirement, you’ll pay tax again. But this is a very minor cost, and it’s not true, as is sometimes claimed, that the entire loan amount is “taxed twice”—just the interest payments.)

There are some additional risks to a plan loan. A big one is that you could wind up leaving your employer before you repay the loan. In a 401(k) plan, if this happens, you must immediately pay back the loan, or it will be considered a taxable distribution—in which case you’ll owe taxes on the loan proceeds, plus any applicable tax penalties if it’s an early distribution (i.e., if you are younger than 59½). This can make a cash-crunch situation even worse, so you need to be very sure you’re going to stay at your employer long enough to repay the loan.

In addition, some borrowers defer new contributions into their 401(k) plans while they repay their loans. This is a permanent loss of an opportunity to save on taxes on your retirement assets, and can be a significant disadvantage later. But if you have to stop contributing to your 401(k) in order to repay a plan loan, presumably you’d also have to stop contributing to make payments on an alternative loan outside the plan. This isn’t a reason to choose an alternative loan over a 401(k) loan—it’s just another reason not to borrow at all in the first place.

Vanguard.com has a neat plan loan calculator that will show you the estimated cost of a plan loan (as well as the cost of an alternative loan). The tool emphasizes the cost of the loan in terms of the investment returns you’d potentially give up. It’s very useful information, but you do need to be careful in interpreting it. The rate of return you assume on your plan assets should line up with what you think you’d receive if you took little or no investment risk (think money market account).

It’s simply not true that giving up stocks in your retirement plan in exchange for a loan will result in a certain loss in the future value of your plan. Ask anyone who borrowed against the stock portion of their plan assets in early 2008. They’re likely to be quite happy that, thanks to the loan, their plan balance won’t fully reflect recent stock market losses. This is just the flip side of a more obvious fact: Borrowing outside the plan at a fixed rate in order to invest in stocks inside the plan does not produce a certain profit. Doing the reverse doesn’t create a certain loss, either. So, use a money market rate in estimating the “return give up” cost of the loan.

With a money market rate of interest as a baseline, you’ll generally see that a plan loan can make very good financial sense if you are in extreme circumstances and absolutely have to borrow. But if you aren’t in such a situation, remember there are always significant costs to borrowing, no matter what the source. Paying cash up-front is generally always the cheapest way to obtain the things you want in life. Don’t treat your retirement plan as a slush fund!

Notes:

• All investments are subject to risk.
• When taking withdrawals from an IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax.