Warning Clients On 401(k) Loans

• DAISY MAXEY for the Wall St Journal writes: Within the past few weeks, adviser Marc Shaffer has heard from two clients looking to tap their 401(k) plans, one for a family emergency and another to purchase land on which to build a home.

As the economy makes a painfully slow recovery, financial advisers like Mr. Shaffer continue to hear from cash-strapped clients who are considering borrowing from their retirement accounts to meet emergency needs or pay for major purchases, like land, homes or business expansions.
"I don't know if it's a result of the market being where it is or what," says Mr. Shaffer, a principal of Searcy Financial Services Inc. in Overland Park, Kan. "Some have taken [401(k) loans] because it's what their option is; others have taken home equity loans." 

In many cases, advisers say, they succeed in deterring clients by pointing out the drawbacks of 401(k) loans and laying out alternatives that are less disruptive to their retirement nest eggs.
But not always. 

In Mr. Shaffer's case, the client who needed the money for a family emergency--the adviser was never told what that emergency was--went ahead with the loan. He was a neonatalogist who had no other cash on hand, but felt he could pay it back quickly, the adviser says. 

The other client, who considered a loan to buy land, opted instead to refinance his home, partly on Mr. Shaffer's advice. The adviser laid out some of the drawbacks of a 401(k) loan, including the fact that the loan is paid back with after-tax money, which is taxed again when it's withdrawn in retirement.
Pam Dumonceau, president of Consistent Values Inc., in Greenwood Village, Colo., says borrowing from one's 401(k) is "a precarious last resort." She's convinced some clients not to tap into their retirement plans. 

"Most of the time, I brainstorm with them about every other possible solution first, then I inform them of the consequences," says Ms. Dumonceau, who's affiliated with Asset One LLC, which manages $348 million. "Sometimes it is the last resort and you've got to do it. It's still better than losing your house or having cars repossessed." 

Among 401(k) participants, 12.5% initiated new loans in 2012, down from 12.7% in 2011 and 13.9% in 2010, but still higher than the 10.6% level in 2008, says Aon Hewitt, which expects the loan-usage rate to remain flat this year. 

The fact that account holders who take out 401(k) loans are paying themselves back with interest may be blinding them to the far-reaching drawbacks, advisers say. 

There's the loss of compounded tax-deferred growth of the borrowed money. Also, contribution rates tend to be lower as the loans--which often range from 5 years to 20 years--are paid back. Worse yet, those who lose their jobs are generally given just 60 to 90 days to repay the loans. If they default, those younger than 59 1/2 years old face a 10% early withdrawal penalty in addition to income taxes. 

A recent study by New York Life Retirement Plan Services underscored the downside: The average contribution rate for a 401(k)-plan participant with a loan is 5.63% compared to 7.23% for those without a loan. In addition, more than two-thirds with an outstanding loan who leave their employer end up taking a distribution rather than paying back their loan. 

For clients who can be convinced to leave their accounts alone and are in position to secure money via other sources, Ms. Dumonceau of Consistent Values recommends that they borrow on a home-equity line of credit or take an unsecured, low-interest personal loan. Even applying for a credit card with 0% interest may be a better option, she says. 

Still, she says, for those with no real choice, a 401(k) loan may work. It can work well, for example, for a small-business owner who wants to expand by purchasing a piece of equipment or real estate and who's certain he can make the payments, she says. However, Ms. Dumonceau would still rather see such an investor take a small-business loan secured by the real estate, which can be had at reasonable cost if the borrower has good credit, she says. 

Last year, one of her clients borrowed from his 401(k) to pay off credit-card debt with interest of 12% to 21%. He had a secure government job and no home equity, she says. "You must not run up those credit cards again," she warned him. 

Gil Armour, an adviser with SagePoint Financial Inc. in San Diego, says he's had more clients suggesting 401(k) loans since 2008, as spouses have been laid off, income has diminished and debts have been called. Clients are also more likely to take a distribution when leaving a job rather than rolling over their 401(k) assets, he says. 

The privilege of 401(k) loans is often abused, he says. Some investors consider such loans "found money" to be used when the car breaks down or their credit cards build up, he says. Instead, they should be setting money aside for an emergency. 

"I generally caution people against doing it," he says. Sometimes, a client is able to borrow from a family member instead, he says.