To Raid or Not to Raid: 401k Loans

The Wall Street Journal shares two opposing articles today, each taking on the topic of 401k loans:

A cautionary tale leading to the SEAL act

In spite of decades of advice to the contrary and the improving economy, millions of Americans are increasingly turning to what was once a lender of last resort—their 401(k) plans.

In 2010, about one in seven workers borrowed from a 401(k) plan, according to new data from human-resources consulting group AON Hewitt. Companies that run the plans report double-digit increases in borrowing from 2009: up 14% in Vanguard Group Inc.-run plans; up 11% in plans run by T. Rowe Price Group Inc. Today, almost 30% of 401(k) savers have a loan outstanding, the highest in recent history.

That is too many, says a pair of senators. Last month, Sens. Herb Kohl (D., Wis.) and Mike Enzi (R., Wyo.) introduced the Savings Enhancement by Alleviating Leakage in 401(k) Savings Act (or SEAL Act), which would, among other things, ban products that promote withdrawals, such as 401(k) debit cards. “While having access to a loan in an emergency is an important feature for many participants, a 401(k) savings account should not be used as a piggy bank,” Mr. Kohl said in a statement.

Still, there are enough strings attached to these loans that financial advisers have typically cautioned against them. The loan can stand only as long as you are employed by the company. Lose your job, and the full balance is due, within 60 days, or it is counted as an “early withdrawal,” and the borrower will have to pay income tax and a 10% penalty on the balance if he or she is younger than 59½.

“A loan from your 401(k) has the potential to leave deep, deep wounds,” says Thomas Muldowney, a financial adviser with Savant Capital Management in Rockford, Ill.

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A financial perspective down to the numbers

Still, if you have urgent legitimate spending needs or high-cost debt you want to erase, tapping your 401(k) might make sense. Although a few retirement plans charge interest rates of 10% or more on loans, the most common rate is currently just 4.25%—compared with 11% on personal bank loans and 13.4% on credit cards, according to the Federal Reserve.

Even Mr. Utkus has borrowed from his 401(k). “I’ve used it for cars, I’ve used it for housing improvements,” he says.

From your portfolio’s perspective, taking out a 401(k) loan is like adding a bond position: you are plunking down a chunk of cash in order to receive a steady stream of interest income. The difference is that the interest comes out of your paycheck, rather than from the issuer of the bond.

Borrowing from your 401(k) at 4.25% to pay down credit-card debt at 13.4% gives you a return of more than 9%, points out Ms. Hess of Aon Hewitt, even if stocks or bonds go down in value. That return is virtually risk-free, unless you leave your job before you have paid off the loan.

Say you borrow $10,000 from your 401(k) at 4.25% for a one-year loan to pay down a credit-card balance carrying an interest rate of 13.4%. If you had left the money intact in your 401(k), you might have earned a 5% return on a 50/50 mix of stock and bond funds, giving you $10,500 after a year. With the loan, your interest payments go back into your 401(k), so when it matures in a year you will have returned $10,425 to yourself.

In exchange, you have not only eliminated $1,340 in credit-card interest charges, but prevented them from continuing to mushroom. Here, taxes don’t matter, since paying off either loan requires after-tax dollars.

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About thebenefitblog

Eric is a Producer at Lockton Insurance Brokers, Inc., the world’s largest privately held commercial broker. Eric has over 23 years of experience in the insurance industry and has spent the last 11 years with Lockton. Eric specializes in Health & Welfare Benefits, Retirement Planning, and Executive Benefits. Eric's clients utilize his expertise in the areas of Plan Due Diligence, Transaction Structure, Fiduciary Oversight, Investment Design, Compliance and Vendor negotiation to improve the operational & financial outcome for each client. The Benefit Blog is a place to share that expertise and industry news.
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