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.

Looking for financial advice? Click here to send David your questions and they might end up as a topic for his next column.

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.

The interest rate paid on a 401(k) loan typically falls within 1 or 2 percentage points of the prime rate, significantly lower than what's usually paid on a credit card, auto loan or other consumer debt. However, borrowers can often do better with a mortgage or home equity loan thanks to lower rates and the mortgage interest deduction.

Li and Smith offer a list of four questions potential 401(k) borrowers might ask themselves before taking out a 401(k) loan through an employer:

1. If you did not borrow from your 401(k), would you borrow that money from some other source (e.g., credit card, auto loan, bank loan, home equity, etc.)?

2. Would the after-tax interest rate on the alternative (non-401(k)) loan exceed the rate of return you can reasonably expect on your 401(k) account over the loan period?

3. Would you be able to make your 401(k) loan payments without reducing your regular 401(k) contributions?

4. Are you comfortable with the requirement to repay any outstanding loan balance within 90 days of separating from your employer, or pay income tax and a 10 percent penalty on the outstanding loan?

A "yes" answer to each of the four questions could mean a 401(k) loan is a better option, according to Li and Smith. A single "no" suggests other option should be considered.

I'm not ready to abandon my general advice against 401(k) loans, but the Fed research paper is making me think about circumstances under which one might not be such a bad idea.

I certainly wouldn't use a 401(k) loan to finance a fancy vacation, but if you face a pressing financial need and don't have access to other low-cost borrowing, then it might be worth considering.

But tread carefully.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com.

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