Recession Solution: Rethinking 401k Loans

401k

A 401(k) loan might not be such a bad idea after all.

For a financial planner like me, those words practically amount to heresy.

But a recent paper by two Federal Reserve economists is questioning the conventional wisdom that says borrowing money from your 401(k) account usually is a bad idea.

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Fed economists Geng Li and Paul A. Smith argue a 401(k) loan can be a good idea for consumers who otherwise would be paying higher rates of interest on a credit card, auto loan or another form of borrowing.

In a paper titled "New Evidence on 401(k) Borrowing and Household Balance Sheets," Li and Smith estimate that households eligible for a 401(k) loan could save an average of $275 a year in borrowing costs if they shifted to a 401(k) loan from higher-rate debt.

That savings could be even higher for loans with big balances and particularly high interest rates.

I stumbled across Li and Smith's paper -- published in May -- while doing research for my column last week about why most 401(k) borrowers are forced to pay off their loans when laid off from a job.

Their argument intrigued me because it runs counter to what I and most other financial planners long advised. The fact Fed researchers were making this argument -- even though not official Fed policy -- meant I had to give it some serious consideration.

Financial planners argue that borrowing from your 401(k) robs you of potential investment earnings, strips away the tax advantages of a 401(k), leads to lower retirement contributions and exposes you to tax penalties in the event of a job loss.

Li and Smith challenge one of the tax arguments and in other cases suggest the advantages of a 401(k) loan can outweigh the disadvantages.

I outlined my objections to a 401(k) loans in a column written early last year in which I used myself as an example of what not to do. I called the 401(k) loan I took out in the mid 1990s to help finance the purchase of my family's first house "one of the dumbest financial moves we ever made."

Li and Smith, however, cite two key advantages to a 401(k) loan.

First, the 401(k) loan reduces interest payments to outside lenders.

"Indeed, since the 'borrowed' assets are already owned, a 401(k) loan is really just a withdrawal coupled with a schedule of replenishing contributions (with interest)," Li and Smith wrote.

The second advantage they cite is the lower transaction costs compared with a loan from an outside lender.

The Fed economists acknowledge the "opportunity cost" of 401(k) borrowing that results when funds are withdrawn from an account and therefore lose their potential to earn investment returns and grow into a nice nest egg by retirement.

They also point to the danger a 401(k) borrower could be forced to pay off a loan immediately if laid off or otherwise face hefty taxes and penalties.

In fact, they recommend changes that would allow borrowers to make 401(k) loan balances portable, moving from employer to employer, or allow borrowers to continue paying down a balance gradually after leaving a company.

For now, however, most 401(k) plans require borrowers to pay off loans in full when they leave a company.

Still, for consumers who carry hefty credit card balances or other expensive debt, a 401(k) loan may be a better alternative, Li and Smith argue.

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