401(k) loans can put future at risk

The days of using your house as a piggy bank are over, and it's harder to get a consumer loan these days. So where are Americans turning to finance college, buy cars and get credit card companies off of their backs? Their 401(k) plans.

As of June 30, 21.9 percent of workers with 401(k) plans had loans outstanding, up from 19.3 percent in 2008, according to Fidelity Investments. The average initial loan amount was $8,650, about where it has hovered for the past decade.

This pattern has played out before. At the start of the 2001 recession, 18.4 percent of active participants had a loan. By June of 2004, that number had risen to 21.1 percent. Many don't have an alternative.

"The economy (is) forcing some people to find additional money to cover their living expenses," Beth McHugh, Fidelity's vice president of market insights, explained.

In general, financial advisers consider 401(k) loans a last resort. They recommend first turning to emergency savings and taxable accounts for fast cash. Problem is, the financial services industry has put such an emphasis on saving for retirement that short-term savings has been given short shrift.

Roth IRAs -- accounts designed for retirement savings that have more lenient rules for taking out contributions -- are another option.

Ross Dahlof, whose business is helping employers design 401(k) plans and advising participants, tries to get a sense of why the client is considering a loan.

"Are you really solving a problem by taking a loan to pay off credit card debt? There's probably a bigger problem and that's probably spending," Dahlof, a consultant with Minnetonka, Minn.-based Christensen Group, said. If you'll still be staring at major financial troubles even after cracking your nest egg, it should be noted that 401(k) assets are protected in bankruptcy.

Scot Hanson, a certified financial planner in Shoreview, Minn., has seen loans work out for clients, like the time someone needed a bridge loan for a down payment on another house, or when a spouse used the money for a college degree and paid off the loan with future higher earnings.

But he's also seen people use retirement funds to go on vacation, buy a snowmobile or juggle vehicle payments. "In my opinion, these are terrible reasons to get a 401(k) loan," he said.

Here's another potential trap: When someone with a 401(k) loan loses a job (and is under the retirement money-tapping age of 59 1/2) the loan must be paid back in a matter of months. Otherwise it's considered a distribution and could be subject to taxes and penalties. If you needed the loan in the first place, my guess is you wouldn't be able to pay it back in a squeeze. Fidelity plans to examine 401(k) loan default rates in the future.

Then there's the risk of falling short of your retirement goal. "You would miss out on that extra compounding you were getting on that money you took out," said Mary Guillaume, a Wayzata, Minn.-based wealth adviser for UBS Financial Services. Of course, that's presuming that the market is going up.

And it's likely that you'd end up contributing less toward your retirement while paying off the loan. Most companies allow you to make contributions with a loan outstanding, but could you really afford both?

Planners also always cite the fact that interest and principal payments are made with after-tax dollars, whereas the 401(k) money you borrowed was pretax dollars.

On the other hand ...

There are those who argue that 401(k) loans have some appeal. Getting the loan is a cinch compared with other loan processes. Request a loan by phone or online, and a check usually shows up within the week. You pay yourself interest on the loan. There's no credit check and the loan doesn't show up on a credit report. Origination fees typically run about $50 and not all providers charge maintenance fees.

Then there's the argument that 401(k) loans could improve your financial health. Federal Reserve economists Geng Li and Paul Smith estimated that households would have been $5 billion richer in 2007 if they'd opted to pay off pricey consumer debts with 401(k) dollars. That amounts to an average savings of $275 per household, the researchers noted. They also suggested allowing gradual repayment of loans in the case of job loss. That would reduce a key risk of 401(k) borrowing, especially in today's economic climate.

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BASICS OF 401(K) LOANS:

The IRS has rules regarding 401(k) loans, but employers have the right to impose additional rules, or to prohibit loans in the first place. Here's what's set in stone:

--Total loans outstanding can't exceed 50 percent of your vested account balance, up to $50,000. Some plans allow you to take more than one loan so long as you don't surpass the loan limits.

--Loans must be paid off within five years, unless the loan is used to purchase a primary residence.

--Payments must be made at least quarterly. Many companies set it up so money is paid back through automatic payroll deductions.