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401(k) Loans: Senate Bill Aims to Set More Limits

According to a recent Investment News report, a bill introduced in the U.S. Senate, would limit workers' ability to take out 401(k) loans. The legislation would cap the number of loans at three per employee and prohibit 401(k) debit cards. The bill would also give borrowers longer to pay back such loans before incurring penalties.

According to consulting firm Aon Hewitt, about 28% of people with 401(k) plans had outstanding loans in 2010.

But is taking a loan from your 401(k) plan account really a good idea?
Whether or not it's a good idea to take a loan from your 401(k) plan account depends on what you are doing with the money. Most retirement plan experts will say to never take any money from your 401(k) plan because you are taking money away from what you will need for a financially secure retirement. In respect to taking withdrawals well before retirement, I would agree. But laons are another story.

When a 401(k) Loan Can Backfire
The biggest risk of borrowing from your 401(k) is that most plan rules require repayment within 30 to 90 days of leaving your employer. That's a disaster for someone who gets laid off or fired. If you don't have the money to pay off the loan it will be included in income as a taxable distribution. If you are under the age of 59 1/2 you'll owe a 10% penalty tax on top of applicable federal and state income taxes. If you don't have the money to pay the tax, the IRS can collect what you owe by deducting it from your remaining balance, virtually wiping out your retirement savings in the plan.

We can all agree that it may be best to leave the money that will eventually have to be paid to the IRS in a retirement plan earning interest for as long as possible. But if the ultimate measure of your financial well-being is your Net Worth (Assets less Debts), then taking a loan from your 401(k) plan to pay off debt has no immediate impact on your Net Worth. The debt paid off is replaced by the loan from your 401(k). There are good reasons to take a loan from your 401(k) plan account, under the right circumstances.

Another thing to consider is that the funds taken from your 401(k) plan could be invested and earning a rate of return, which is not a sure thing. But if the debt you are carrying is guaranteed to cost 18 percent, taking a loan from your 401(k) to pay down 18 percent interest debt is essentially the same as locking in an 18 percent rate of return.

Here another example of when taking a loan from your 401(k) plan might be advisable. Let's say you want to buy a home, but you don't have enough cash for the down payment to get a good mortgage. Your choices include: a). getting a non-conforming mortgage with a higher interest rate and mortgage insurance, b). waiting until you save the down payment and miss out on a low-priced home and low mortgage interest rates or c). borrow the down payment from your 401(k) account. For some people, the better option may be the 401(k) loan.

The advantage of taking a loan from your 401(k), when it's used to secure or purchase a primary residence, is that the loan can be paid back over 15 years, or over the term of the mortgage for the home. The loan is qualified as a "principal residence loan" and the interest paid qualifies as an itemized deduction as "qualified residence interest".

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