Recession Solution: Rethinking 401k Loans

Aug 4, 2009 — -- 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.