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Study: 401(k) loans a long-run worry

Allowing loans from 401(k) plans increases participation and contributions but could reduce retirement savings in the long term, a new government report concludes.

Permitting 401(k) participants to borrow from their accounts "may be a double-edged sword," the General Accounting Office said.

Loan features boost participation in a 401(k) plan by about 6 percentage points, the GAO reports. The effect on employee contributions is even stronger. According to the GAO, average annual contributions are 35 percent higher in 401(k) plans with loan provisions than in plans that bar loans.

Couple that with matching contributions from an employer and the effect can be dramatic, lifting average 401(k) savings to about $1,500 a year, up about $600 from plans with no loans or matches.

A typical 401(k) participant in a plan with matching and loan provisions will save more than an identical participant in a plan with no such provisions, the GAO finds _ putting away 8.6 percent of pay, versus 4.9 percent.

Loan features aren't unusual. About half of all 401(k) plans allow loans, usually on better terms than an individual could get through a bank. Unless they're used to finance a primary residence, 401(k) loans must be repaid within five years.

But interest rates are "very favorable," the GAO points out, with most plans charging the prime interest rate plus 1 percentage point. Principal and interest is repaid to the account.

Loans do have a major downside, the GAO warns, as those who borrow from their own accounts run the risk of having "substantially lower" balances at retirement. For that very reason, some employers who offer a 401(k) plan refuse to allow loans.

Trading sizzling stock earnings for a low, single-digit interest loan rate could slash retirement income by as much as 20 percent, the GAO cautions. Losses could be as low as 7 percent if borrowers keep contributing to the 401(k) while repaying loans.

IRS increases

401(k) ceiling

The Internal Revenue Service has increased the amount of money U.S. taxpayers can deposit into their 401(k) plans every year.

In 1998, individuals will be able to place up to $10,000 into 401(k) accounts, up from the current level of $9,500. The IRS adjusts the contribution caps every year to account for inflation.

A 401(k) plan is a company retirement fund that is invested in stocks, bonds or money markets. Companies often match a portion of the employees' contributions.