I recently heard from a family that wondered about taking a loan out of the 401(k) — or maybe a hardship withdrawal.
Did somebody lose a job? Was it hard to pay the mortgage? The car note?
No. The mom told me the son needed braces that would cost about $5,000.
Bad idea? Not necessarily.
Right now, let's consider our economic world where credit card companies are stingy, consumer loans are tight or priced high out of reach, and home values are so low that some families can no longer take out a home-equity line of credit.
I wouldn't recommend taking a 401(k) loan for holiday shopping. But — I cannot imagine I'm saying this — the loan might be reasonable for essentials, such as braces.
Two economists at the Federal Reserve Board in Washington wrote a paper this year that suggests households could save roughly 20 percent — or about $275 per year — of their overall interest costs if they opted to borrow money from their 401(k) plans instead of taking on expensive consumer debt.
The interest rate that many people pay on a 401(k) loan is the prime rate plus 1 percent — or 4.25 percent now — but rates vary.
With the plans at General Motors and Ford, for example, the borrowing rate is the prime rate, 3.25 percent currently.
No credit checks are required, so if you had a bad credit score, you would not pay a higher rate.
While you might think that everyone is rushing to raid the 401(k) in a bad economy, the statistics show otherwise.
Last year, about 18 percent of all 401(k) participants eligible for loans had a loan outstanding against their 401(k) plan, the same percentage for the two previous years, according to a study released this month by the Employee Benefit Research Institute and the Investment Company Institute.
The median loan balance was $3,869 in 2008, down from $4,167 in 2007.
Not all plans offer loans.
Under the law, participants are allowed to borrow up to 50 percent of their vested account balance or up to $50,000 — whichever is less. There is a possible exception if 50 percent of your vested account balance is less than $10,000. In that case, according to the Internal Revenue Service, you'd be able to borrow up to $10,000. However, the IRS notes individual company plans are not required to offer you this exception.
Also, your plan may limit the number of loans you can have outstanding or the amount of time within loans.
Do not ignore the pitfalls of a 401(k) loan.
First, what happens if you lost your job?
If you leave or lose your job, you could have to repay the entire outstanding loan nearly immediately after you leave some companies.
At other companies, you might owe all that money within 90 days to avoid a tax headache.
If you do not meet the deadline in such cases, any unpaid amount will be distributed to you as income, and will then be subject to federal and state income tax. If you are younger than 591/2, you may be hit with a 10 percent early-withdrawal penalty, too.
If you retire or are terminated, you must keep making regular payments to avoid a default.
Second, be warned there can be a huge cost when you stop investing.
If the stock market is miserable, you're fine.
If stocks rebound and show gains of 8 or 10 percent or higher, you're losing out.
Pamela Villarreal, senior analyst for the National Center for Policy Analysis, a free-market think tank in Dallas, noted that taking a $30,000 loan out of a 401(k) plan and paying it back over five years could leave some retirees with $200,000 less at retirement. Use a 401(k) loan calculator at www.retirementreform.ncpa.org.
The Federal Reserve economists — Paul A. Smith and Geng Li — said it's key to make regular 401(k) contributions while repaying the loan.
In general, loans must be repaid within five years. Loans from a 401(k) for the purchase — not refinance — of a principal home may be repaid within 15 years.
Still, should you avoid taking a 401(k) loan? Absolutely.